Two Reasons Why Stocks Will Probably Fall Again
I’m seeing a lot of bullish signs in the market lately (five, specifically).
They’re leading me to suspect that stocks will climb for the next few months and in 2023 overall.
But just because the evidence suggests something will happen… does not mean it is certain to happen.
And if we look at all the evidence, there’s reason to suspect that the opposite might happen, too.
On Tuesday, I laid out all the reasons why we might see stocks rise over the next few months.
Today, I’m going to cover why we might see another crash between December and February 2023.
Bearish Datapoint No. 1: Valuations
The massive bull market between 2009 and 2021 caused valuations in the stock market to soar.
“Valuation” effectively means the difference between the price of something and what it actually produces (i.e., fundamentals). When price is high above an asset’s fundamental worth, it is considered overvalued. When price is below that fundamental worth, it is considered undervalued.
So you can have an asset that’s overvalued one month and appears unattractive as an investment… and then, the next month after a huge price drop, it might appear undervalued — even if nothing has changed with the underlying fundamentals or worth of the asset.
(This, by the way, is the central strategy of DIYwealth’s flagship portfolio, the Heritage Portfolio: Buy great assets when they appear fairly valued or slightly undervalued.)
Now, 2022 marks just the 11th time since 1950 that the S&P 500 drew down -20% or more from its most recent all-time high.
So with this price decline, does that mean the market is now undervalued?
Unfortunately not.
Look at a few measures of valuation and you’ll see this clearly.
The Shiller CAPE ratio is one of the most highly predictive valuation metrics ever created. It divides the S&P 500’s current price by its 10-year moving average of inflation-adjusted earnings. A higher ratio could reflect lower returns over the next several years.
Even with the recent drop, the market still looks pretty wildly overvalued:
Here’s another indicator: U.S. Market Capitalization as a percentage of GDP.
This is called the “Buffett Indicator” and it measures the aggregate value of the U.S. stock market relative to the country’s economic output.
A Buffett Indicator reading of 100% means that the market is fairly valued.
Where is it after the recent drop? It’s at a very overvalued 148%.
One more indicator: Tobin’s Q.
This measures the market value of one or all public companies in the U.S., divided by their combined asset values. A reading above 1 means prices of stocks are higher than the actual value of their physical assets, implying that the market is overvalued.
As you can see in the chart below, this indicator is still far above 1:
To summarize what all these indicators are telling us…
The market still looks very overvalued.
Now, that doesn’t mean stocks are going to inevitably crash more. After all, valuations were high throughout the entire bull markets in the mid-1990s and over the last 12 years.
Plus, I’m currently working on an article for an academic financial journal that argues that average stock valuations are going to continue trending up now that passive index funds and high liquidity have invited more and more retail investor money into the market.
Regardless of all that, though, with current valuations being what they are? The market would either need to drop another -25% or earnings would need to increase by about 25% in order for the market to be “fairly valued.”
If the U.S. is going into a recession, then you shouldn’t be expecting earnings to increase. Certainly not that much.
That makes another market decline substantially more likely in early 2023, after we start seeing companies reporting earnings for the last few months of 2022.
Bearish Datapoint No. 2: The Impending Recession
There is no better signal that an economic recession is about to occur than inverted yield curves.
To explain this indicator simply: long-term (think: 7 to 30 years) sovereign bond yields are almost always higher than short-term (3 month to 2 years) bond yields.
When short-term yields are higher than long-term yields? That means investors are selling short-term yielding bonds (sending these yields higher) and buying long-term bonds (sending these yields lower).
This phenomenon has occurred before every economic recession since 1970.
For U.S. bonds, 2-year treasury yields have been higher than 10-year treasury yields since July 2022.
And 3-month yields were higher than 10-year treasury yields briefly on October 18.
For that reason, I can confidently predict that the U.S. will enter a recession in 2023.
It will likely begin after we see unemployment rise and the Fed pivot back to quantitative easing.
Now, this might seem scary.
But as I always say, I see a looming recession as an opportunity for long-term investors.
In the March 2022 issue of one of my paid newsletters, I shared some analysis from the CME Group:
“When the economy is strong, consumer and business spending increases and corporate profits improve. Greater profits support higher stock prices. Conversely, when economic activity slows, spending declines, profits are reduced, and stock prices fall. The stock market typically continues to decline sharply for several months during a recession. It historically bottoms out approximately six months after the start of a recession and usually starts to rally before the economy picks up.”
You can see the connection between recessions and market declines in the chart below:
Important to note…
Most of the “pain” felt by investors occurs in the last 6 to 12 months before a recession even occurs!
So many financial prognosticators are saying that the market correction we’ve been in was just the beginning of this financial pain. And that the decline would continue until the U.S. officially enters a recession.
Now, I wanted to dig deeper, so I loaded in every single date since 1980 that both the 3-month and 2-year yields were higher than the 10-year yield. And I found what the stock market returned 1 month, 3 months, 6 months, 1 year, and 3 years later.
Here’s what we see when yields invert:
1 Month: -0.1% on average
3 Months: -0.1% on average
6 Months: -0.4% on average
1 Year: -2.8% on average
3 Years: 5.9% on average
So while stocks do drop on average for a year after yields invert…
That movement is minimal. Nothing to be super frightened about.
And for long-term investors? The market breaks positive after 3 years on average.
That’s an exceptionally powerful point to keep in mind for buy-and-hold investors (like yours truly), since the entire time stocks are “down” during a recession, we’re receiving dividends and increasing the number of shares we own.
Plus, the high volatility that occurs during market drops enables long-term investors to receive higher option premiums for selling puts and calls on the blue-chip stocks we wish to own anyway. (I teach readers how to do this in another one of my paid newsletters, the Cash Alert, which you can access here).
Ultimately, that typically enables our long-term portfolio to recover faster and gain more than the overall market.
All of the information above?
It’s why I’m increasingly bullish and positive about the stock market, but still not insanely bullish and positive.
That’s why, with my own money, I’m remaining conservative, gradually investing in great stocks (you can find my exact recommendations here), and keeping a stockpile of cash to deploy just in case.
I recommend you do the same. Stay safe.
