Overvalued Stocks Are the Main Catalyst for Upcoming Market Fall
The next financial crisis could already be in the making. By some measures, the U.S. stock market is overvalued by 63%. Reversion to the mean would make for a lot of sleepless nights.
According to John Hussman, a fund manager with a record of success, a stock market decline of 63% would adhere to the same norms that prices have revisited or breached during the completion of nearly every market cycle in history. Put another way, Hussman believes that the S&P 500 could trade in the three-digit range again. (Source: “Broadening Internal Dispersion,” Hussman Funds, August 14, 2017).
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As of this writing, the S&P 500 is trading at around $2,460.00.
Also Read: Warren Buffett Indicator Predicts Stock Market Crash in 2017
There’s a good reason why valuations have been tightly correlated with long-term returns. It’s because the impact of variations in interest rates and growth rates systematically wash each other out. Wall Street’s most followed valuation metric, the price-earnings (P/E) ratio, didn’t attract a huge following for nothing. It is followed, quoted, and disseminated so readily because it works. Consistently and throughout history.
The strength of valuation correlations throughout time is the reason why it’s never “different” this time. The market always cycles back to its historical valuation ranges, because the relationship between growth and interest rates are bonded. For this to sever, growth would have to trade permanently at historic levels; low interest rates can only take the market so far.
Any reversal in rates or growth will severely impact market pricing.
Stock Overvaluation Giving Final Warning Ahead of Next Financial Crisis?
Reckless lending in the property market was one of the main causes of the financial crisis. The dynamic is different this time. The upcoming calamity will be valuation-driven.
However, many investors are living under the false assumption that low interest rates will prevent the market from falling. That’s a dangerous ideology to cling to. According to Hussman, zero-bound rates have historically been the thin edge dividing overvalued markets and collapse. If investors become risk-adverse for whatever reason (in this case, valuations), widening divergences can lead to large market sell-offs.
In other words, low rates prime the pump, but won’t prevent a collapse if investors become timid.
If there’s any doubt about this fact, remember Japan. Low interest rates were unable to jump-start growth, despite the transitory quarter-or-two demand boost. Even with rates essentially zero (where they are today), the Nikkei 225 never recovered. By March 10, 2009, the Nikkei closed at 7,054.59, which is down 81.89% from the all-time high.
Needless to say, zero-bound interest rates didn’t save Japan, and Hussman doesn’t believe they will save America.
The fact that the Nikkei 225 rose on different fundamentals doesn’t matter. The lesson is that zero-bound interest rates were unable to rekindle growth and stock market values. Everything else is just details.
The next financial crisis will be even worse. Or, at least, it has the potential to be worse. Sixty-three percent downside potential is no laughing matter. That’s what the mean reversion models say is likely possible and, obviously, such an outcome would destroy many portfolios in the process.
Investors shouldn’t count on low interest rates (assuming they even continue) to save them. As Japan’s experience shows, that’s no panacea.
