Market Crash – Waiting for the World to Fall

Photo Credit: Orange County Archives

We are currently living through the largest financial bubble in the history of mankind.  Stocks, bonds, real estate, private equity, crypto-currencies, and even some collectible categories are all grossly inflated in value.  Our current financial mania is broader in scope and larger in magnitude than the 1990s Dotcom bubble, the 1720s South Seas bubble, the 1980s Japanese Nikkei bubble, the 1920s Dow Jones bubble or the 1630s Dutch Tulipmania.

It is the perfect setup for a devastating market crash.

Now I understand full well that making predictions about the financial markets is a quick way to become a liar.  They are so unpredictable that you can simply never say never.  And indeed, what reasonable person would have thought that the U.S. stock market would exit the 2008-2009 Great Recession – the worst economic contraction since the Great Depression of the 1930s – and then proceed to bloom into the greatest financial apostasy of all time?

I have to admit that I didn’t see it coming.

Of course, the real question is where do we go from here?  The conventional wisdom is that we’ve entered a new era of perpetually rising asset prices.  Stock market indices, real estate markets and crypto-currencies of all types will simply waft forever higher on their own smug sense of self-satisfaction, while their owners become rich, rich as Nazis I tell you!

Reality, however, is a harsh mistress.

I suspect that rather than spiraling higher into the financial stratosphere over the next few years, we are much more likely to experience a destructive market crash, or a series of lesser market crashes.  The historical parallels and mathematical realities governing our current predicament are just too brutal to have a happy outcome.

But why would I forecast a market crash when such events are rare throughout financial history.  Is our current “Everything Bubble” really that bad?

In a word, yes.  The Everything Bubble is so enormously overvalued as to be obscene.

For example, the S&P 500 index sports a sky-high price-to-sales ratio of 3.21 as of July 2021.  From the late 19th century right up until 1995 this ratio averaged around 0.8.  Since the Fed began blowing serial bubbles starting in the mid 1990s, the S&P 500 has averaged a somewhat higher ratio of around 1.5.  But this still pales in comparison to the 3.21 price-to-sales figure the index currently enjoys.

A 50% haircut in the major U.S. markets would barely bring this ratio down to an “elevated” average.

I like using the price-to-sales ratio as opposed to price-to-earnings ratios for a couple reasons.  First, sales tend to be far less volatile than earnings.  It isn’t unusual during recessions for earnings to turn negative, but sales rarely drop by more than 10% or 15%, even in highly cyclical industries.  This makes movements in the price-to-sales ratios far more subdued, which in turn gives the observer a much clearer view of the economic fundamentals.

Earnings are also subject to a tremendous amount of hype and fluff.  For instance, companies will often tout misleading EBITDA (earnings before interest, taxes, depreciation and amortization) or operating earnings (sometimes known as EBBS or “Earnings Before Bad Stuff”) to pump up their quarterly numbers.  And it is difficult to know whether the P/E ratio you’re looking at is using trailing 12-month GAAP, forward 12-month estimated GAAP, trailing 12-month operating or forward 12-month estimated operating earnings in its calculations.  No such confusion exists with price-to-sales numbers, which always use the actual trailing 12 month values.

Finally, it is far easier for an unscrupulous company to alter its earnings in a fraudulent manner than it is to fake sales data (although both can happen).

Looking at a chart of the S&P 500 index’s price-to-sales ratio is enough to induce vertigo.  Being a valuation metric, this ratio should lazily meander around a perfectly horizontal average with relatively modest variation on either side.  Instead we see an ascent on Mt. Everest, with the ratio blasting off from the COVID 2020 lows in a nearly vertical manner.  These sorts of blow-off top moves are a hallmark of late stage asset bubbles and nearly always resolve in a market crash.

 

Photo Credit: multpl

 

Another key indicator flashing red is the market cap of all U.S. stocks and bonds outstanding compared to GDP.  Much like the price to sales ratio above, this valuation metric is very, very reliable.  I first wrote about this important barometer back in 2018, but since that time it has gone completely bonkers.

As of Q1 2021 the total U.S. securities outstanding-to-GDP ratio stands at an unprecedented 565%, having risen sharply in just the past year.  But before 1991, the ratio had never risen above 200%.  Indeed, even during the very worst of the 2000 Dot Com bubble and 2007 Housing bubble the ratio never surpassed 380%.

This valuation measurement is so important because it not only takes into account the stock market, but also the bond market.  In fact, the well known Buffett ratio, which tracks the total market cap of U.S. stocks compared to GDP, is just a subset of this valuation metric!  But the total U.S. securities outstanding-to-GDP ratio is a more holistic tool than the Buffet ratio in isolation.  Every time a barely solvent company issues an ugly looking CCC-rated junk bond or a unicorn technology startup goes public, it is reflected in this all encompassing ratio.

To call total U.S. securities outstanding-to-GDP’s current level repugnant is an understatement.  If we were to return to the historical norms that prevailed pre-1990, both the stock and bond market would have to take a combined 73% loss.  And because stock investors sit in a first loss position vis-à-vis bond investors, it implies a truly disastrous Depression-level event for equity indices – potentially an 85% or 90% market crash!

Either that or we avoid a market crash via hyperinflation.  Fun choice!

 

 

But hyperinflation – a crutch leaned on by far too many financial pundits these days – is an unlikely outcome, even against a backdrop of trillion dollar deficits and an ever expanding Federal Reserve balance sheet.

Under more normal economic circumstances, high inflation would mean rapidly growing nominal GDP and falling real debt loads.  This would make equities a more enticing proposition versus bonds because companies have an implicit inflation-adjustment mechanism – they can just raise prices for their products (if the market will bear it)!  These increased prices lead to additional revenue and earnings for firms in a persistently inflationary environment.

Market crash averted, right?

Not so fast.  The problem is that empirical observations of both U.S. and foreign economies do not reveal much evidence of inflation (excepting the temporary post-COVID spike).

Instead we see a troubling pattern where each successive recession leaves corporations, governments and average citizens more heavily indebted than before.  As the economy gradually becomes debt-saturated, more and more resources are diverted to paying the interest on these crushing obligations.  Consequently, non-essential economic activity slowly gets choked off leading to loss of pricing power, stagnant wages and disinflation, not inflation.

We can verify this by looking at a chart showing year-over-year nominal U.S. GDP growth rates over the last few decades.  I’ve added trendlines in red to show the average growth rate during periods of economic expansion.  The evidence is unambiguous – average nominal growth has been lower in every successive expansion since the United States cut the dollar’s last link to gold in 1971.

The Financial Crisis of 2008-2009 was particularly damaging, with nominal GDP averaging 5.3% before the crash and only 3.7% afterwards.  It is anybody’s guess just how low average nominal GDP will go in the aftermath of the COVID recession.  But there is at least one indisputable conclusion we can reach: absent massive changes to existing fiscal/monetary policies, nominal U.S. GDP will be lower over the course of the current expansion than the miserly 3.7% rate it achieved during the last expansion.

 

 

Persistently low growth and future disinflation does nothing to mollify fears of an imminent stock market crash.

Although I’ve peppered you with a multitude of frightening looking charts, one does have to exercise a degree of caution with valuation tools.  They can’t be used to time markets.  There have been countless instances when an already overvalued market simply ignored reason and became even more overvalued.  And there is nothing to say it couldn’t happen this time either.

But there are signs everywhere that this market cycle is far advanced, stumbling ever closer to a treacherous peak than any sort of harmless trough.

The first exhibit in our menagerie of speculative excess is the crypto-currency market.  Bitcoin, of course, needs no introduction, but it is the other, lesser cryptos that I would like to focus on for a moment.  These less well-known – although perhaps more infamous – crypto-currencies are often collectively termed “shitcoins” by a skeptical crypto community.

I measure speculative fervor in the crypto-currency space via two methods.  The first is the total market cap of all cryptos put together.  Because the space is dominated by Bitcoin, that particular token constitutes the bulk of outstanding market cap (usually between 40% and 70% of the total).  Aggregate crypto-currency market cap peaked in May of 2021 at an astounding $2.5 trillion.  To put this amount into perspective, it is believed that all of the above-ground gold in existence is worth perhaps $10 or $11 trillion.

Although the total market cap metric is quite useful, it has limited applicability with regard to shitcoins because they tend to have small market caps relative to Bitcoin, Ethereum, Tether and the other big boys.

That is where my other measurement tool comes into play – tracking the number of cryptos that have individual market caps greater than $1 billion.  In spring 2021 we hit 105 cryptos – mostly shitcoins – with a market cap of at least $1 billion.  This includes illustrious and desirable virtual currencies such as Ox (ZRX), Avalanche (AVAX), THORChain (RUNE) and my personal favorite, SushiSwap (SUSHI).  BakeryToken (BAKE) was a close second.  With names like these, how could you not be assured of great future wealth, honor and surgically enhanced women hanging off every arm?

That last sentence was sarcasm, by the way.  In reality, the price action we are seeing in shitcoins is a classic sign of financial mania.

 

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The speculation in the crypto-currency space has become so extreme that otherwise intelligent people are “investing” in shitcoins that they know are probably fraudulent because the allure of easy money is simply too great.  Bloomberg recently ran a great article on the topic titled “Crypto Scammers Rip Off Billions as Pump-and-Dump Schemes Go Digital“.

Here are a couple money-quotes from the article:

 

“‘Everybody I know has gotten rug-pulled [been the victim of a pump-and-dump scheme],’ says Titus, a 38-year-old butcher in Salem, Oregon.  ‘You know, you win some, you lose some.  Hopefully, win more than lose.'”

 

“Many who feel they’ve been ripped off just shrug. They chalk it up to the cost of doing crypto, the price of buying a lottery ticket that maybe just might hit that big jackpot.”

 

My God, is humanity dumb.  We keep repeating the same financial mistakes again and again, apparently forever.

Fortunately (or maybe unfortunately, depending on your viewpoint), this intensity of speculative fervor can’t persist for very long.  The crypto space will either have to continue delivering amazingly high returns (even taking into account all of the pump-and-dump schemes), or it will implode in on itself in spectacular fashion (while taking many peoples’ savings with it).

In any case, a future market crash is assured; it is merely the timing that is uncertain.

Another area where we see speculative price action reaching a frenzied peak is in that old favorite of market gamblers everywhere: the S&P 500 Index.  I’ve created a chart showing the S&P 500 from the spring of 2009 (which was the bottom after the Great Financial Crisis) to July 2021 (the latest data available).  I then segmented the chart into 5 distinct rallies during that 12 year period.  Finally, I drew a linear trendline in red through each separate rally.

 

 

The results are stunning.

It shows that each successive resurgence in the S&P 500 during the recent bull market has enjoyed a steeper slope than its immediate predecessor.  As “investors” (I put that term in quotation marks because they are really gamblers) become more assured that the stock market is a perpetual escalator up, they buy the next dip more aggressively.  As a result, each subsequent rally is more extraordinary than the previous one.  It is true that each runup in stocks is interrupted by a brief sideways market action or minor decline, but this merely serves as a prelude to the next dramatic ascent.

When you zoom out, it is clear that the entire edifice takes on the appearance of an exponential curve – a hallmark of financial market manias spanning the ages.  Perhaps most worryingly, the trendline angle of our current rally is well in excess of 70 degrees – a thoroughly unsustainable angle of attack.  For all you geometrically challenged people out there, a 90 degree rally would be perfectly vertical.  This doesn’t mean we can’t have another market drawdown or consolidation followed by an even more extreme melt-up, but such an outcome is cosmically improbable.

Instead it is far more likely that our speculative mania reaches its natural endpoint and swan-dives into a magnificent market crash – Fed be damned!  Few financial market participants are prepared for an event of this magnitude.

The final area where speculation has exploded within the past couple of years is certain niches within the collectibles market.  Magic the Gathering cards, comic books, modern sports cards, video games, sneakers and Pokémon cards are all collectible categories that have experienced frenzied trading and price increases.  Although an important catalyst for these moves was undoubtedly the spring 2020 lockdowns associated with COVID-19, pricing has since taken on a life of its own.

For example, a 1993 Magic the Gathering Black Lotus (alpha) card is more than $50,000 in the summer of 2021, a 300% increase from its price just 3 years ago.  A 1999 Pokémon Charizard Holo 1st Edition certified PSA 10 is $350,000, a nearly 800% increase over the same time.

Meanwhile, in the world of vintage video games a factory sealed, Wata 9.8 certified copy of 1996’s Super Mario 64 for the Nintendo 64 console brought a cool $1.56 million in a July 2021 auction.  And that record-breaking sale eclipsed a Wata 9.0 certified early production run Legend of Zelda Nintendo game cartridge from 1987 that had sold for $870,000 just days earlier.

The speculative excess in these collectable categories is truly breathtaking.

 

Photo Credit: MTG$

 

If you read my website at all, you know I’m a proponent of using fine antiques as an investment vehicle, but that enthusiasm does not extend to the collectible space.

The collectibles that are skyrocketing in price are largely made of plastic, paper and cardboard.  Most can’t even be used for their originally intended purpose without destroying their value as collectibles.  They are nothing like the antique jewelry, sterling silverware, old coins and other high value objets d’art that I recommend savvy investors accumulate.  These venerable antiques are made from some of the most enduring, desirable substances on earth – stuff like gold, silver, gemstones and exotic woods.

I would also like to point out that the piranha-like price action in the vintage collectibles space is tightly confined to those items from the 1980s, 1990s and early 2000s.  This is not a coincidence.  I believe that collectibles from this time period are shooting up in price for one very good reason.

The Millenials in their 20s and 30s who are speculating on these items have never seen a real market crash in their adult lives.  The last truly significant market decline was the 2008 to early 2009 timeframe.  Since that time, the Federal Reserve’s Everything Bubble has persistently risen regardless of the macroeconomic backdrop.  Young people – anyone below the age of about 35 or so – have come to believe that bursting bubbles and crashes are myths told by old investors to scare them out of the markets.  They have also conflated gambling with investing due to having no point of reference for what a normal, reasonable market looks like.

In contrast, most collectibles from the 1960s and 1970s – Hot Wheels cars, Barbie dolls, PEZ dispensers, Hummel figurines, etc. – are dead in the water.  These older collectibles have seen effectively no price bump at all during the last few years.  In fact, their prices have been declining!  I attribute this to the fact that older collectors who would normally be buying these items are too experienced to fall for the ridiculous arguments about never ending demand and perpetually rising prices.

We are in the midst of the greatest investment mania of all time.  But as euphoric as investors, speculators and gamblers in various asset markets are today, there are sure to be tears tomorrow.  A market crash is coming.  I can’t tell you when and I can’t tell you how, but it is coming.

I will leave you with a quote that famed economist Roger Babson made in a speech on September 5, 1929, just weeks before the Dow Jones bubble burst:

“Sooner or later a crash is coming, and it may be terrific.”

I believe we are living in similarly dangerous times.  Protect yourself.  Buy cheap assets like precious metals and high quality antiques.  Make certain to hold large cash reserves.  Don’t use leverage.  A market crash may be frightening, but you can survive it if you act now.

 

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