Stocks Will Fall 36% In The Next Bear Market

Earnings Estimates Done Going Up

There has been a sharp multiple compression this year which makes it less likely stocks will crater. Stocks had a correction in February, but are up year to date. The compression has come from earnings estimates increasing dramatically in the past 3 months. As you can see from the chart below, the earnings revision ratio hit the highest level since at least 2002. The question investors now need to answer is whether these earnings projections were already priced in to the market before they occurred, or if the market has room to run because of them. The thesis behind the market having room to run is that it has simply been preoccupied by short term noise such as the tariffs and the short volatility trade unwinding. The stock market reacts to every news event, so its performance can be cluttered. For example, on Tuesday the market reacted to a potential denuclearization of North Korea, Speaker of the House, Paul Ryan, being fine with targeted steel and aluminum tariffs, and the President’s chief economic adviser Gary Cohn potentially resigning over this tariff discussion.

As you can see from the chart below, the 2018 and 2019 earnings estimates look like they are peaking, just like I said they would last week. Unless there’s an unforeseen boost in growth later this year, I see $160 or higher of earnings in 2018 as almost impossible. On the other hand, I think $156 or lower in earnings is likely. Speaking of multiple compression, with these results, the 10 year Shiller PE will fall. It’s difficult to fully understand the Shiller PE because it’s not predicting a crash in 1-2 years since it’s not a short term mechanism. It could either be saying stocks will fall hard when the next recession occurs or that stocks will have a shallow bear market, but there won’t be a sharp recovery.

Next Bear Market

Obviously, you don’t want to own stocks at the beginning of a bear market. However, if you have an estimate of how much stocks can fall, you can figure out a level you’re comfortable dipping you toe in the water. The chart below comes up with an exact forecast of the size of the next bear market based on the weighting of each sector. The Shiller PE assumes sector weighting has no effect on the market’s long term performance because it believes margins mean revert. If the blended S&P 500 margins always mean revert, then it doesn’t matter what the weightings are.

The theory behind this reasoning is that each sector has competition which eventually erodes high margins. That theory doesn’t hold up in practice because sometimes government provides barriers to entry. Also, the software industry has had high margins throughout its existence. High tech margins are one reason why some investors discount the Shiller PE. They say this time is, in fact, different. I think the Shiller PE’s logic is counter-intuitive because there have been long periods where a sector has had above average margins. However, I wouldn’t ignore the Shiller PE completely because of its great track record.

Either tech margins will have a sharp reversion in the next cycle or they will fall along with every other sector and rebound with them. It’s an interesting discussion. The one situation where tech margins could come down is if there are regulatory fines on the big tech names. If you are willing to believe sector weightings matter because each sector will be impacted by the next recession equally, the table shows stocks will fall 35.25% if the next bear market is an average one. That caveat explains my next point which is that if a recession is centered around one sector, such as tech or financials in the last two, than the results could differ.

A tech decline makes stocks the most vulnerable to a crash since it is the largest sector. The weakness in energy and materials in 2016 didn’t cause a bear market. The recent weakness in telecom, utilities, and consumer staples is considered good news because it means the ‘risk on’ trade is working. The other aspect the table shows is consumer staples have been the most resilient to the previous 5 bear markets, while telecom and utilities have done poorly. It’s common to see stocks converge in declines because people panic out of all stocks, throwing the baby out with the bathwater.

Chance Of A Recession

I’ve shown a few recession indicators in the past few months. Most of them show a moderate increase in the odds of a recession in the next 12 months, but none give an outright prediction of one. The chart below is unique because it shows there is one metric which is forecasting a recession. As you can see, when you combine the term spread with valuations, the critical threshold is met. It’s not surprising to see this because the yield curve is relatively flat and valuations are high. In the past 30 years, there has never been this large a gap between the indicators where only one is above the threshold. None of the other indicators are close to reaching the threshold.

It’s the ultimate valuation call. Do you believe in economic timing metrics or do you blindly sell because of high valuations? Usually, the indicators match valuations, but the length of this cycle and the size of the rally makes it different. Because I don’t think valuations are a catalyst for a recession, I disagree with this one metric. I reviewed the chart because it’s the only one showing the probability of a recession meeting an important threshold. It’s an extremely tough market for value driven investment managers, which is why it’s best to be fluid. If you don’t adapt to the market, you will underperform for long swaths of time. Eventually, value will become more popular, but it hasn’t been doing well for years as you can see from the chart below.