I argue that another crash, followed by a bear market, is coming in the fall of 2020 in the U.S., the likes of which we have not seen since the 1929 crash and more recently with the 2008 crisis. With it comes the once in a century opportunity to shift to a golden age of finance in the aftermath of an (hopefully) short-lived severe recession/depression.
A crash is defined as a surprising fast drop in stock market values. It is an abrupt double-digit percentage drop in a stock index over the course of a few days. By extension, a bear market occurs when stock prices fall for a sustained period, dropping at least 20 percent from their peak. It is worth emphasizing that I am not referring to the March 2020 crash, but rather predicting a second and more severe one in the fall of 2020.
My argument is laid out in three main points:
1-Economic fundamentals and expectations are not well priced by the market right now.
We are in a market bubble.
I illustrate this with a valuation of the index using Required Yield Theory (Faugère & Van Erlach, 2009) and a new indicator of such bubbles, I call the B-indicator, introduced here.
I will take for granted that the reader will catch up, if necessary, with the basic knowledge and performance of Required Yield Theory (RYT). (Note 1)
Running the model for the S&P 500 as of August 31, 2020 produced a valuation of 1745 for the S&P 500, whereas the index level was at 3508, meaning that the index was overvalued by 101%!
A previous calculation on March 9, 2020 had produced an overvaluation of only 7% and on May 12, 2020 one of about 27%.
The driver of the overvaluation gap in May was the fact that expected 1-year-forward S&P 500 earnings-per-share estimate had been revised downward by about 25% vs. prior assessments.
However, since then, the fear premium (Faugère & Van Erlach, 2009; Faugère, 2013) has increased by 68%, which has been an additional valuation depreciator in August 2020. To sum up, RYT points to a widening gap between fundamental valuation and the market price for the S&P 500, i.e. this is an accelerating bubble.
In periods of crises, gold is used as a safe haven instrument. Faugère & Van Erlach (2005) show that in general, the real price of gold tends to move inversely with the S&P 500 P/E ratio. When the index price drops faster than expected earnings, then the price of gold should rise (everything else constant).
However, a remarkable and strange pattern was visible in July and August 2020. On a daily basis and looking at 15 minutes ticks, there were series of days for which both the S&P500 and gold prices were moving in concert (Fig1 below).
This is surprising given the safe haven role we expect gold to play.
A possible interpretation is that there currently is a great tension between bullish vs. bearish stances, or between fear and greed.
The increase in gold price reflects the conviction that the financial market is about to collapse, or that the U.S. dollar is losing value from the standpoint of risk averse investors.
At the same time, the bulls remain convinced that the U.S. economy will rebound fast in 2021, and wittingly or unwittingly ignore the structural cracks in the U.S. economy and policies.
The conclusion is that in periods where the gold price and S&P 500 are co-moving and the S&P 500 is situated close to its recent highs, we might be witnessing bubbles.
In order to operationalize this intuition, I constructed a measure I call the B-indicator that captures these co-movements in the daily returns of gold and the S&P500 .
What are the results? Over the period 19/11/2004 to 12/08/2020, the B-Indicator correctly identifies 9 (mini) bubbles out of 15 signals with July-August 2020 being the latest to date.
Required Yield Theory asserts that all assets are priced so that investors earn a required yield after inflation, taxes and behavioral premia. This required yield equals long-term GDP/capita growth.
In Faugère & Van Erlach (2009) and Faugère (2012) we show that RYT can solve many of the puzzles usually associated with valuation of equity, at the level of a market index.
Required Yield Theory was applied to the 2008 financial crisis and over the 2004-2011 period, produced a 5.8% mean absolute percentage deviation from actual index level on a daily basis (Faugère, 2012). One of the key ingredient of RYT is the consideration of a fear premium in the valuation formula.
The model takes into account marginal tax rates (capital gains, interest and dividend income), expected earnings per share, expected inflation, Treasury yields (corrected for QE distortions), a fear premium (3% in August) and a required yield of 1.3% (corresponding to post 2015 estimates of expected long-term U.S. GDP/capita growth).
The fear premium is the sum of an (after-tax) (1) flight to liquidity premium and (2) flight to safety premium. (1) is calculated as the shortfall of the after-tax one-month T-bill yield from the after-tax nominal federal funds target and (2) as the shortfall of after-tax nominal 30-year Treasury yield from an after-tax long-term trend (Faugère, 2013).
Figure 1: 10 days graph ending 7/21/20: S&P500 (SPY price in black) vs. GLD price (light brown)
2-Why is it that a significant number of U.S. market crashes happen in October?
Out of the top 20 largest one-day percentage losses going back to 1899, almost half of them did happen in October.
There could be justifications for why some crashes happen in October. This has to do with a new type of bias I call “uncertainty-forced-resolution”.
This is a direct cousin of the famous ambiguity aversion bias (Ellsberg, 1961).
The ambiguity aversion bias is the tendency to favor the known over the unknown, including known risks over unknown risks.
It refers to a case where people get psychologically “frozen” when they face uncertainty and ambiguity.
I assert here that when such a situation arises and people experience a high level of psychological strain, they will force the issue and “resolve” this ambiguity in their minds by taking an action, rather than remaining stuck with that uncertainty.
A useful metaphor is someone lost in the forest without compass or phone. While the person may choose to remain where they are, paralyzed by fear and uncertainty, at some point they will choose to act. Maybe they will try to send visual signals. After they have tried several things onsite, they eventually will start walking in a particular direction.
The direction they choose is the one they have worked out in their mind, which will give them the greatest chance of survival, whether they are objectively correct in that choice or not. I call this psychological reaction uncertainty or ambiguity-forced-resolution.
In the context of the October effect, the logic goes as follows. First, there has to be a macro level of ambiguity/uncertainty present before entering the summer months with great potential downside risk. During the summer months, investors and traders at large will sit on this uncertainty.
They prefer the status quo, waiting for new information flows to resolve this uncertainty.
There is no rush, as the investing and trading activities are scaled back during summer months. However, in the fall, with the return to full-on trading activities (after Labor Day for Americans), investors will choose to act to resolve the ambiguity and make the most risk-averse choice they have at their disposal to ensure their “survival”.
Here, I test a small aspect of that hypothesis. I examine the level of and increase in ambiguity/uncertainty in the months right before October. I use two data sets to capture ambiguity/uncertainty in the flow of information investors have access to.
The first measure is the Financial Stress Indicator (FSI) developed by Püttmann (2018). The second is the Historical Economic and Policy Uncertainty Index developed by Baker et al. (2016).
I ask the question: were the levels and/or growth rates of the index (FSI or HEPU) abnormally high right before major October crashes?
I find that this is true for the 2002 and 2008 crashes. For the 1907 crash, I find an important acceleration of uncertainty/ambiguity.
The FSI index is supportive of strong levels and/or increases of ambiguity for the 1929, 1987 and 1997 October crashes.
The uncertainty and ambiguity conditions for a crash that are prevailing as of September 2020 are far worse than those of September of 1929.
The high level of ambiguity and mixed signals that prevailed during the summer of 2020, and are still prevailing as of September 2020, is nicely illustrated by these Yahoo Finance August 3rd 2020 news headlines (Figure 2).
On the same page, you see headlines pointing 180° from each other. These mixed messages and schizophrenic analyses presented side-by-side, have been a mainstay of news headlines during the whole summer.
A few days later, on August 12, 2020 economist Yanis Varoufakis wrote in a tweet “Financial capitalism has decoupled from the capitalist economy, skyrocketing out of Earth's orbit, leaving behind it broken lives & dreams.
As the UK sinks into the worst recession ever, & U.S. edges toward failed state status, FTSE100 goes up 2% & S&P500 breaks all time record!” We were in a world of ambiguity and contradictions then and still are today.
Some interesting parallels can be drawn between 1929 and 2020, especially looking at the months leading into October.
Table 4 below summarizes fundamental ambiguities/uncertainties that were present in these months. There are striking similarities between the two eras.
Nonetheless, the scope and magnitude of the pre-October 2020 economic and political uncertainty dwarf those of 1929.
Table 4: Comparison of Leading Factors of Ambiguity/Uncertainty in the US-- 1929 vs. 2020
|By 1929, the effects of the last (1918) pandemic had completely subsided.||Coronavirus Pandemic. A second, third wave? A vaccine? (6 months/1 year horizon uncertainty).|
|Unemployment rate low at 3.2%||Unemployment level 10%+. Resorption?|
|High private leverage (margin debt). No large public debt||Historically high margin debt (Fig. 3). High private corporate debt ($10.5 T in Q1 2020). High private personal debt ($4 T in Q1 2020). (Source ST Louis FRED). U.S. government debt and deficit have risen since March 2020. An added $2.2T to the deficit over the next 10 years (CBO estimates).|
|Pro-business economic policies with President Coolidge||Health and economic policies (including trade wars).|
|Booming tech revolution up to 1929. Indices of industrial production slightly falling by the summer of 1929, and a softness in construction activity in 1928. Flailing sector: Agriculture (crop prices and revenues generally falling over the 1920s).||Q2 GDP drops -31% (annualized) from Q1. Flailing sectors: transportation (air, road), car rental companies, recreation (cruise lines), restaurants, oil, steel, etc… V-shaped or U-shaped recovery? Speedy mean-reversion in earnings?|
|January 1929. New U.S. President (Coolidge leaves Hoover arrives. Both republicans). However, there were no major differences in announced policies and transition was smooth.||U.S. Presidential election and rising political instability and civil unrest.|
|Bubble: Stocks rose by over 150 % between 1922 and 1927. Overvalued stocks in 1929 (new high tech: RCA, GM, Seaboard Air Line). RCA split-up shares. Many stocks were valued as much as 30 times earnings||Bubble: overvalued stocks (stay-at-home high tech: FAANGs). Apple splitting shares. Apple valued at 35 times forward earnings. Increased corporate share repurchase programs in 2018 and 2019.|
|1927-- Federal Reserve complies with request from European central bankers to lower the rediscount rate. In March 1929, the FED discourages speculative loans and call rates go up to 20%. Mitchell (Head NY FED) goes “against” the FED’s stance on speculation and announces that his bank will lend to prevent market liquidations, which generates policy ambiguity||Federal Reserve committed to more quantitative easing and lowering rates ($3 T additional purchases). Changes policy objectives in September (new uncertainty about commitment to control inflation).|
|Shadow banking risky positions. The call loans market and levered investment trusts financed by U.S. corporations and foreign banks. The share of funds in the call loan market that were coming from lenders outside the Federal Reserve System (i.e., non-banks and foreigners) rose from 24% at the start of 1928 to 58% in October 1929. By 1929, new trusts were launching at a rate of nearly five per week, and these offerings were taking in one-third of the new capital raised.||Shadow banking: Bitcoins competing with the banking monetary circuit and gold as safe haven.|
Levered ETFs. Banks’ risky positions: Goldman's latest 10K (2019) shows that the firm has up to 70% of its credit portfolio in non-investment grade or distressed corporate loans.
|Conflicting views of experts about the likelihood of a crash (September: Babson vs. Fisher). Bearish views of NY Times experienced writer Alexander Dana Noyes||Conflicting views of market experts: Dalio, Mauldin, Roubini, Schiff, vs. Jagerson and Hansen.|
The elephant in the room no one is talking about is the level of private leverage and margin debt, which have reached historical highs in the U.S. (even though margin debt recently dropped down a bit from its peak in 2018).
Figure 3 below shows that in the case of the 2008 crisis and the March 2020 crash, the gap (normalized to 0 in 1999) between margin debt and the S&P 500, had greatly widened, and subsequently dropped due to deleveraging.
These observations fit with the often-cited cause of the 1929 crash as being the triggering of margin calls (Galbraith, 1988).
It also fits The Financial Instability Hypothesis laid out by Minsky (1992) and further elaborated by Keen (1995), which points to overleverage as a chief cause of financial market crashes. The gap is widening again in July 2020.
Figure 3: Margin Debt and the S&P 500 Quarterly 1999-2020
(Source: Yahoo Finance and FINRA) Both series are normalized to 1 as of December 1999
3-Why should we care about this next market crash?
People are fascinated by market crashes.
The sense of thrill and danger can be hypnotizing and it makes for great press coverage. But beyond the drama or wild market movements, what is the relevancy of these events for investors? For long-term investors, the answer is: not much.
The average time to get back on one’s feet from a bear market is about 4.4 years. Looking at Table 5, for our small sample of selected crashes, we see that for an investor in a diversified index portfolio with more than seven years to spare at the outset of a crash, the net result of a buy-and-hold strategy is that they will not lose any capital during that time-period. *
*The exception is the 1929 crash. However, the reason why investors had to wait 25 years is because of a series of compounded events unrelated to the 1929 crash. For instance, the start of WWII had a great negative impact on the market.
Table 5: Recovery Time from Crashes/Bear Markets
Maximum % loss
|Time to recover to pre-crash level|
(peak to peak)
|October 1907||38%||2 years 11 months|
|October 1929||86%||25 years|
|October 1987||27%||1 year 11 months|
|October 1989||6%||8 months|
|October 1997||7%||1 month|
|October 2002||42%||6 years 7 months|
|October 2008||51%||5 years and 5 months|
|March 2020||34%||6 months|
Time to recovery computed using Shiller’s historical data on the S&P 500 available at: http://www.econ.yale.edu/~shiller/data.htm
It has been argued for many years that there is a disconnect between the fortunes of Wall-Street and those of Main-Street.
This is even truer nowadays. Notwithstanding the gap between the economic performance of publicly traded corporation and their stock performance, which is emblematic of a bubble, the sector of the economy being hit hardest by the crisis, the small-business community, is not represented in major stock indexes like the Dow and the S&P 500.
Movements in the stocks of Apple, Microsoft, Amazon, Facebook and Google’s parent company are dictating the action in the S&P 500 more than ever before.
The pandemic has accelerated work-at-home and other trends that have boosted Big Tech’s profits. The five big tech-oriented giants are now worth a combined $7.6T and by themselves account for about 23% of the S&P 500’s total value.
In light of these market trends with the frequent bubbles it generates, a valid question to ask is: does the stock market fulfill its economic mission today? A primary function of the stock market is supposed to be the allocation of capital to help companies grow. Yet fewer and fewer companies seem to turn to the market for help.
The stock market is also a major avenue for pension plans and other funds to invest. Perhaps the simplest explanation for the shift from public to private equity is the needs and demands of institutional investors (Mauboussin & Callahan, 2020).
Currently, the U.S. is facing an impending crisis as U.S. pension plans warned they will run out of money by 2028 (Pension Policy International, June 1, 2020. Pension plans and mutual funds are seeking higher returns than those provided by fixed income instruments and are more or less forced to load up more risky investments and private equity is one such outlet.
What to do when the market crashes in October 2020? A standard answer would be to ride the crash all the way down and invest when stocks are worth a penny on the dollar. But, this time it is different. The resounding call is for social and environmental responsibility.
For years, corporations have resisted adopting CSR policies. In the last decade, many of them have shifted to the point that CSR is a major part of their stakeholder’s communication strategy. But in actuality, only a small portion of their revenues and assets are dedicated to socially and environmentally sustainable investments.
The world has entered a new era following this major COVID-19 environmental/health crisis. It is time to prepare for the next crises.
We already know what they look like: warming temperatures leading to extreme weather events and severe crop failures around the world, rising sea levels leading to migration of coastal populations, natural resources and eco-diversity depletion, and the potential unleashing of more viruses with the thawing of Arctic and Antarctic frozen lands and increased human interaction with displaced wildlife.
We no longer have the luxury of procrastination, as these crises are upon us, within this generation.
Hence one thing is clear, the strategy of investing in the same old non-sustainable businesses to “make a few more bucks” will not help investors having chosen pure greed over preparedness and foresight.
Maybe both objectives can be pursued jointly, but one must keep the real goal in mind, which is at this point to make sure humanity will thrive in an environment that is set to change quite drastically. Thus, we must remain mindful of the forces that motivate us to take action on the financial market, and choose those which are aligned with this goal.
I suggest five main strategies for investors and funds to navigate the next crash and come out as a force of positive change:
- Build a coalition of large funds with a sustainable agenda (Calpers, NYSLRS, etc…) who will sell their stakes in “sin” and/or low ESG score companies and buy equity in new sectors supporting the ecological transition.
- Create a new type of exchange (conditional on SEC approval) where sustainable ETFs are traded, in which blended portfolios of small to medium size corporations engaged in the ecological transition + ecological transition type bonds + private equity placements are securitized. These new types of exchanges would track two market measures: a financial one and a societal performance one.
- Use public-private partnerships to raise capital for sustainable projects already receiving government funding.
- Anticipate a possible collapse of the dollar, based on current FED balance sheet policy and move to assets traded and quoted using an alternate digital sustainable money.
- Buy blockholders’ stakes in low priced “sin” companies to alter the course of their governance and strategic choices towards a sustainable path, though large shareholder activism.
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