Collapse: It Always Comes at the Wrong Time

Written by John Peterson
Posted October 11, 2018 at 8:00PM

The market is a cycle.

That's the first thing you learn as a finance student, an economist, or a trader. Nothing is constant — except for change.

It a perfect world, a world of market equilibriums, the business cycle shows steady and measurable ups and downs. It shows expansions and contractions, recoveries and recessions, booms and busts, peaks, and troughs. In a perfect world, it looks like this:

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But we all probably realize that this isn't a perfect world. So, in reality, the cycle looks more like the image below. It displays the averaged measure of the U.S. business cycle, with recessions shaded:

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The range of emotions that you feel about the market is probably similar to the one you felt during your last roller-coaster ride — excitement, thrill, euphoria, anxiety, fear, panic, hope, and relief:

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There are ups and downs in this roller-coaster market. Sometimes, these are extreme ups and extreme downs. And no extent of monetary or fiscal policy can prevent the severity of those swings.

The market is a scary place. All we can do is mitigate inevitable volatile occurrences and try to control the fallout.

Unfortunately, we can't always see these events on the economic horizon because they occur outside the realm of the usual economic indicators. We call those events "black swans."

A black swan has three characteristics...

It's unexpected — a surprise. Its occurrence falls outside of regular expectations. It could be a war, an election, a terrorist attack, or the bankruptcy of a large firm — Lehman Brothers, anyone? Even media headlines, about the economy or not, can be black swans.

Following its occurrence, there are extreme economic effects.

Despite its unexpected nature, there are sometimes indicators of black swans that we only notice retrospectively. So, these events are actually predictable in a sense. We just usually fail to predict them. Hindsight is 20/20.

Black swans have occurred in the past. They'll continue to occur in the future. And they'll continue to inflict dramatic shocks. The clearest way to follow these is in the Dow Jones Industrial Average (DJIA). The outcomes aren't always negative. Let's look at a few:

  • October 1929, Black Monday and Black Tuesday: -13.47% and -11.73%, respectively.
  • November 1940, President Franklin D. Roosevelt's reelection: +4.37%
  • September 1955, President Dwight D. Eisenhower's heart attack: -6.54%
  • September 1955, News of Eisenhower's good health: +2.28%
  • November 1963, President John F. Kennedy's assassination and the arrest of Lee Harvey Oswald a few days later: -2.89% and +4.50%, respectively.
  • September 2001, September 11th terrorist attacks: -7.13%

Most recently, we have the 2008 housing bubble.

Was that a black swan? No.

But we should have seen it. Looking back, we should have known it was coming. Some people did.

John Paulson saw it, traded against it, and made $20 billion in what people now call "the greatest trade ever."

Unless you were John Paulson in 2008, that bubble flew under your radar. Millions of families, maybe even your own, suffered because of it. More than $6 trillion in household wealth was destroyed. The majority of this was felt by the poorest 20% of Americans.

Now, I've got some good news and some bad news...

Bad news first: You're not John Paulson. So, these bubbles and market corrections probably had a negative effect on your financial portfolio.

Good news next: Market corrections and events like the 2008 housing bubble aren't always completely unforeseeable. And you don't need to be John Paulson to figure them out.

Let's look at the two most recent market corrections and try to do some historical sleuthing:

This chart illustrates the ratio between total U.S. market capitalization of all shares outstanding and gross domestic product (GDP), the historical average of which is 50%.

A 100% ratio means that the total market cap is equal to the nation's GDP. In this case, the stock market would be considered fairly valued.

An undervalued stock market would produce a ratio of less than 100%. And so, the opposite is true of an overvalued market.

A good rule of thumb? Tread lightly whenever the ratio exceeds 100%. It's a good sign that the market is overdue for a correction.

Take note of two things here. You can't miss them, because there are two large red arrows pointing in their direction.

The first is the dot-com bubble of 2000. And the second is the housing bubble in 2008.

Between 1996 and 2000, dot-com companies saw their stock prices soar. The Nasdaq exploded from 600 to 5,000 points. In 2000, the market cap-to-GDP ratio reached 136%, an all-time high — until now, that is.

Poorly managed companies with no hope or history of earning profits had market capitalizations of more than a billion dollars. Anyone remember Pets.com? In the end, a total of almost $8 trillion of wealth was lost.

In 2008, the ratio reached 108%. This bubble came suddenly from a combination of stock overvaluation and the collapse of the housing market. Within only five months, the Dow fell by 20% from historic highs of 14,000 to just over 7,000:

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I don't want to bring back nightmares for anybody. But the series of events that followed almost pushed our entire global economy off a cliff.

Right before both of these bubbles burst, stocks were clearly overvalued. In fact, right before essentially every market correction, the U.S. market cap-to-GDP ratio has been over 100%.

Today, the ratio is 127%. You make the connection.

Share valuations are sitting at multiyear highs right now. And we would be foolish to ignore history.

But wait, there's more...

Overvaluation isn't the only thing that 2018 has in common with 2008. Maybe you can figure it out: High-risk, defaulted mortgage loans are to 2008 as ???? are to 2018.

I'll give you some hints:

  • This form of debt ballooned from a total of $253 billion in 2003 to $1.2 trillion today, that's over 70%.
  • 43 million people in the U.S. are tied to this type of loan.
  • This is the only type of consumer debt that isn't decreasing but instead increasing.
  • The average borrowed amount of this type of debt is $35,500.
  • 7 million borrowers are in default of these loans.

The answer? Student loans.

Historically, the next financial step for individuals who recently graduated college would be to buy a home. But now, those grads can barely stay afloat as their monstrous education loans drag them down.

Most students will be 40 years old before their loans are paid off.

Studies show that, because of their looming debt, the majority of recent grads are spending less money, especially on large purchases that stimulate our economy. Even if they wanted to buy a home, their large debt would make it difficult to qualify.

The effects of this large debt are spreading beyond individual graduates. It's dragging down the entire economy and slowing down the recovery of the housing market.

We in the economic community can draw several parallels between past corrections. We can follow historical superstitions; we can consult our corner tarot card readers.

Unfortunately, we've yet to discover a foolproof strategy to detect the next correction. And unless someone invents a time machine or finds a real crystal ball, there's no way for us to know the unknowable. History will have to be our crystal ball.

The only guarantee we have is that a stock correction will happen. There are no "ifs" on this. But what we need to figure out is when it'll happen and why.

Proceed with caution. Here's one way the pros do it. It's worked for years.

That's all for now.

Until next time,

John Peterson
Pro Trader Today

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