Stock Market Crash 2018 (And Beyond) Will Only Occur When Recession Is Imminent
Will the stock market crash in 2018? Investors have been asking the same question for the last five years. Each time, the answer was a resounding “No.” So could 2018 be the year when the dam finally breaks? Many bears would settle for a leak instead of a torrent.
The relentless stock market rally has defied all logic. Corporate earnings growth has been essentially flat since 2013, yet the market keeps rallying. But instead of moving up with conviction, it’s mostly been melting forward. This has led to one-sided trade, with the bulls herded to one side.
The merciless melt-up in stocks is leading to an ultimate paradox for investors. Do investors buy-in at nosebleed levels, or wait for pullbacks to add positions? After all, if the question is when the next stock market crash will happen, nobody wants to be a top-tick bad holder.
The answer to this question, for now, is to dive in head-first.
Inflows into exchange-traded funds (ETFs) have remained incredibly strong this year. Through the first seven months of 2017, $272.0 billion has flowed into the stock markets via ETFs. That’s almost matched the 2016 record inflows total of $287.0 billion. If stock investors are worried about chasing overvalued stocks, they aren’t showing it. (Source: “ETF assets top $3 trillion after huge July inflows,” CNBC, July 31, 2017.)
But there’s danger with investors chasing equities in lieu of any half-decent correction. Some analysts are worried about a one-sided market. This occurs when everyone is investing in the same direction, leading to harrowing sell-offs once investors sell at the same time. So far, any real damage has been confined to a day or two. But this won’t last forever. Investors conditioned to “buy the dip” will be in for a rude awakening soon.
How strong has the market melt-up been? Consider that it’s been 18 months since the market has had a “small” five-percent stock market correction (June 2016 Brexit sell-off). Furthermore, the S&P 500 hasn’t corrected even three percent in over 13 months, the longest streak since 1994. It’s absolutely mind-blowing when you consider all the macro risk, Trump, terrorism… you name it.
Even market veterans are perplexed by the market action.
50-year NYSE Floor Manager Art Cashin is having trouble explaining things. Asked to explain how U.S. stocks have continued to outperform while the 10-year Treasury yields have remained sub-2.5%, Cashin acknowledged that he’s never seen anything like today’s market. That’s telling, considering that Cashin started his career in the 1960s. “I’ve been doing this for over 50 years and I’ve never seen anything like it so it is rather odd.” (Source: “Art Cashin: “I’ve Never Seen Anything Like Today’s Market Before”,” Zero Hedge, October 2, 2017.)
Cashin, specifically, was referencing stocks’ abnormal relationship with low yields. Low yields imply tepid growth and low inflation, which historically is the opposite of what should happen during a rip-roaring rally. That in itself should be an ominous sign. As is the yield curve, which has recently crashed to 10-year lows. (Source: “Yield Curve Flashes Recession Warning In Collapse To 10 Year Lows,” Zero Hedge, September 21, 2017.)
But he might have well been speaking for the entire market ecosystem, which is totally disregarding any traditional key economic indicator followed by investors. Specifically valuation, which, by any standard, is inflated beyond reason.
Will the Current Stock Market Rally Continue in 2018?
By now, it’s common knowledge that the world stock indices have been driven almost exclusively by central bank (CB) liquidity. Not just in America, but Asia, Europe, Japan…everywhere. This is no accident. The world’s CBs are engaging in coordinated loose money policy; much of it conducted through direct bond purchases to suppress interest rates.
Another preferred method by the CBs is purchasing financial assets outright.
The Swiss National Bank currently owns over 2,500 different equity positions. Combined, their stock market portfolio is worth over $90.0 billion. If it were a hedge fund, it would be one of the larger ones around.
SWISS NATIONAL BANK – Top 10 Holding (Latest Filing)
|Company||Class||Value of Shares ($1,000s) ▼||Change in Value ($1,000s)||Change (%)||Shares Held|
|AMAZON COM INC||COM||1,635,478||55,957||3.54||1,481,841|
|FACEBOOK INC||CL A||1,600,102||56,917||3.69||8,760,000|
|JOHNSON & JOHNSON||COM||1,503,170||38,886||2.66||10,738,464|
|EXXON MOBIL CORP||COM||1,343,986||38,689||2.96||16,024,636|
|ALPHABET INC||CAP STK CL C||1,170,061||41,533||3.68||1,140,966|
|ALPHABET INC||CAP STK CL A||1,150,081||37,846||3.40||1,103,089|
|PROCTER AND GAMBLE CO||COM||890,873||24,772||2.86||10,252,888|
(Source: “Swiss National Bank Institutional Portfolio,” NASDAQ, June 30, 2017.)
In years past, central banks left the markets alone (unless the markets were crashing). As we can see, that’s not the case anymore. The combination bond re-investments being plowed back into the markets, direct asset purchases, and low borrowing costs have directly caused the bull market conditions today. Anyone trying to swim against the liquidity tide by shorting the market has been eviscerated.
With all that said, will there be a stock market collapse 2018? After all, it’s about looking forward—not backward. Peering into my crystal ball, I see signs that the current market order is coming to an end.
Why? Because CB liquidity is finally about to dry up. The same forces driving everything sky-high over the past several years are coming to an end. Worse than that, they may actually work against the market. There is no free lunch in economics.
The Fed and ECB are about to halt bond purchases and allow bonds to mature in their existing portfolios. This is the so-called “quantitative tightening” program some people may have heard about.
In America, the liquidity drain is set to peak at around $50.0 billion/month by late spring 2018. That’s a lot of potential liquidity not entering the markets. The Fed has been busy telling us this “normalization” of their balance sheet will be like “watching paint dry.” But it’s not true. A very expensive stock market needs all the liquidity it can muster to keep stocks grinding higher. It’s not Joe Sixpack buying Amazon shares at $1,090 apiece. (Source: “Shrinking Balance Sheet Won’t Be Like ‘Watching Paint Dry,’ Says JP Morgan,” Barron’s, June 19, 2017.)
What happens after the program kicks in is anyone’s guess. But there’s no question that if the market is to continue higher or avoid hardship, it must rely on its own devices.
Are you willing to take that bet?
Are We Heading to Another Stock Market Crash?
Several stock market crash indicators point in that direction. I’m going to focus on one powerful one—the rapidly inverting yield curve.
There’s a reason why the U.S. Treasury Yield Curve is followed so closely by market analysts. It’s historically one of the best market indicators for predicting U.S. recession. It’s accurately called the last seven recessions without producing a false positive.
The most common spreads are between two-year and 10-year; five-year and 30-year. When the shorter duration bonds yield more than the longer bonds, the yield curve becomes inverted. That’s a powerful sign that economic growth (and future expectation of growth plus inflation) is weakening.
The reason for the yield curve’s amazing predictive power is rooted in sound business principles. Why would banks lend out money longer term when they could earn more interest income lending short term? Longer-term lending has a greater risk of default and other disadvantages. Banks become more choosy about the money they shell out for big capital projects when the yield curve flattens out, choking out funding for big capital projects. This affect jobs, the velocity of money, and GDP.
So what’s the yield curve doing now? Despite the fact the economy has grown over three percent for two consecutive quarters, the yield curve is now trading at 10-year lows. Not since just before the Great Recession have we seen 2/10 and 5/30 spreads so low. (Source: “US yield curve flattens to 10-year record,” Financial Times, November 1, 2017.)
The 2/10-year curve (above) isn’t flat yet, but it’s narrowing fast. It suggests the bond market doesn’t like the economic growth picture being painted by the financial media.
Who are you going to believe? More poignantly, does anyone think the market can continue to melt-up if growth falters and the Fed takes away the punch bowl? The answer is self-evident.
Causes & Effects of the Stock Market Crash of 2018
The next Wall Street crash will be brought about by a recession. When corporate earnings collapse, nothing will be able to stop the torrent of selling from one-sided trade from an expensive market. The market trades at a CAPE ratio of about 31 right now. In a recession-induced earnings collapse, the CAPE could easily trade north of 100 if stock prices don’t decline. That’s not happening. Even in the Tech Bubble—the most expensive market in history—the CAPE topped out at around 50.
So what will be the recession trigger? The inability to wring more “consumerism” out of a deeply indebted population. The substitution of income and savings for low-cost debt works out until saturation takes place. After that happens, nothing can stop the inevitable.
When people and corporations run out of the ability to borrow, the system must clear in order for borrowing capacity to return. But the problem is, a massive amount of deleveraging will need to happen to reach that point. Literally, decades of ultra-low rates and stimulus have pushed the credit boom to unimaginable levels.
It’s gotten so bad that the current economy needs roughly $3.00 of new debt to create $1.00 of real, inflation-adjusted, economic growth. Some analysts have suggested about $35.0 trillion of total credit market debt needs to be cleared before the problem will alleviate. The last time deleveraging on that scale occurred was during the Great Depression. (Source: “How Big Of A “Deleveraging” Are We Talking About?,” Zero Hedge, July 25, 2017.)
The returns from the liquidity bubble keep diminishing over time. The check is almost due.
Stock Market Crash Predictions for 2018
Needless to say, I’m quite pessimistic about the stock market’s chances going forward. I believe slower-trend growth will be evident by the back half of 2018, and the CB liquidity drain will weigh on stocks. Shrinking liquidity and slowing growth is a bad recipe for keeping expensive stock prices elevated.
The big question on my mind (besides timing) is whether the eventual sell-off will be orderly or chaotic. With the proliferation of top-heavy ETFs, passive index investors and record margin debt, it’s hard to envision anything orderly about it.
Perhaps central banks will find a way to cushion the blow. But perhaps a perfect storm of market turmoil is brewing. Nobody thinks it can happen in this environment; most can’t even remember the last time it did. And that’s exactly why a bloodbath is a distinct possibility. If the S&P 500 can hold 2,150 in a controlled demolition, I would consider this a major win. Just enough to let some air out without wrecking portfolios for the next 10 years.
Welcome to this grand experiment in controlled “marketomics.” We hope it’s different this time.