Is the US Stock Market on the Verge of Collapse?

That is the take of some very influential market participants in the past year. We look at this question point-by-point and assess the likelihood of such an event, along with the “probable triggers” that would cause the whole thing to come crashing down.​

First, let’s start with a few basic reminders, just to set the tone. Financial market prices represent the aggregate expectation (sum of all participants) of what will happen in the near future (1-2 years). If markets have crashed and market participants think that “the worst is over and things will now get better” (bottoming out), then capital will leave safe assets (short term government bonds) and flock to riskier assets that offer high expected returns with relatively low downside risk in the short-medium run.
 
In the same logic, if most market participants expect that things “can’t get any better and are likely to get worse” in the near future, there will be a selloff of risky assets like stocks, and capital will flock to safety (government bonds), which will of course cause stock prices to drop and stock indices will plunge (and maybe your retirement fund). In other words, stock indices are a “leading indicator” of economic activity. OK.
 
Now, when a leading indicator like a stock index has crashed like it did in 2008-2009, it is normal that it comes back “strong”, simply because profits will probably come back to where they were (and then some) due to improving sales and major cost cutting during the “purge years.” But what makes stock prices continue to increase after a good run? Future expected profits and a few other things. Hence, if current profits are “high” relative to stock prices, stocks may be  “maxed out” and need some small or large correction, and the same logic goes in the other direction, when stock prices to earnings are very low. Still with me? All right. Keep reading…
 
What pumps up stock prices in the US stock market? It boils down to 4 items: i) increasing sales; ii) decreasing production costs; iii) funds flocking into US stock markets; iv) self-reinforcing information feedback loops. All this must be put on the backdrop of the current price-to-earnings ratio. This means it is a combination of a few of the following:

1. Good or improving labor market conditions;
2. Good or improving credit conditions and/or monetary expansion;
3. Major cost-cutting by firms;
4. Merger and acquisition activity and stock buybacks;
5. Good or improving economic outlook in countries where US companies make profits;
6. Lots of global and domestic funds (liquidity or savings) looking for returns and “landing” in the US stock market for various reasons;

 
In the “other direction”, when we want to get an idea of the chance of a crash, one crucial point must be mentioned: debt loads, bubbles, and credit conditions.
 
Let’s look at these items and a few others that could cause major crashes, and evaluate the chances of a minor or major stock market drop in the USA in 2016. Shall we? Let’s Go!
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Current P/E
There are a few measures of this ratio. The standard one, the Shiller “Cyclically adjusted” one, etc. We could argue all night about the fact that this ratio could have structural breaks that shift the average (or “normal”) value permanently upward or downward, but the short story is that as of late February 2016, this ratio is slightly on the high side, thus posing slight downside risk.
 
Labor market
The US labor market is currently in relatively good shape and there are no worrying signs. The employment rate and participation rates did indeed fall and never recovered after 2008, but this has been in part caused by changes in lifestyles and preferences, as well as a demographic undercurrent that was exacerbated by the 2008 shock. There is no significant risk from labor.
 
Credit conditions and monetary policy
Is credit become tighter? The slight monetary policy tightening by the Fed did indeed have effects. Large effects. US funds that were previously parked in foreign markets fled those markets due to currency risk and this roiled global markets (watch videos in the products section if you want to clarify this), creating a mini panic and a general run for safety, into safe bonds and out of stocks, thus causing downward pressure on stock indices everywhere. This causes yield spreads to rise in riskier assets: stocks fall, and higher-yield bond prices drop, thus making risky asset yields rise and spreads to increase, which makes credit tighter.
 
Will this continue and turn into a major crash? No. The entire future Fed monetary tightening is largely priced into all markets, from stocks to bonds to FOREX. There may be a slight surprize effect remaining in the books, which is why stocks have slight downside risk until June-July 2016. But no major and rapid credit tightening is to be expected, thus there is low risk on credit conditions to rapidly deteriorate and cause the stock market to collapse.
 
Production costs
How can we tell if profits come from cost cutting rather than from improving sales. First there is accounting data and data on sales for companies listed on stock markets. Then you could also look at productivity. When productivity increases “faster than average” for a few years, it means that production is increasing more than employment, which means firms are making efficiency gains and cutting production costs, which is good for the bottom line. This happened between 2008 and 2012. Firms were making major efficiency gains. This is less the case since 2013: firms had to start hiring more, which boosted employment. The question is: can firms cut costs in a major way going forward? The strong appreciation of the USD may help on this going forward, as US firms find cheap deals for global M&A opportunities with their purchasing power, and this could help on the production cost side. Hence, this recent USD appreciation may support stocks into 2016-2017, even if it also has a negative impact on exports.
 
M&A and stock buybacks
The past few years have been record years. This was caused by the quest for efficiency gains, sector consolidation, plenty of cheap liquidity allowing to borrow at very low rates to buy other firms, participate in M&A, and do stock buybacks, which pump up prices. The USD appreciation and the cheap credit in massive amounts have allowed and encouraged all this. Is this likely to continue? This could continue for a year, especially with the strong purchasing power of the USD in world markets. Is this likely to sustain stock prices in a significant way? Not likely. This element will likely have a neutral or slightly positive effect on stock prices going forward.
 
Outlook in foreign markets
The rest of the world was hit by the start of QE reversal by the Fed. US capital fled those markets to avoid currency risk, putting downward pressure on stocks, bonds, credit, many currencies, and housing in foreign markets. On top of this, the appreciation of the USD has made US exports less competitive. This has decreased sales of US multinationals to the rest of the world due to the slowing economies of its main trading partners, Canada, China, and Mexico (in that order). This adds slight downside risk to US stock markets, but most of it is now priced in.
 
Global and domestic funds
A massive amount of liquidity still remains “floating around” in markets, and global savings is more-than-proportionally flocking to US markets. The gradual QE exit could be almost fully counterbalanced by massive liquidity injections by other central banks around the world, creating global capital movements in favor of US financial markets. The gradual QE exit will not have hard landing effects because the majority of the impact is already priced in, as can be seen from a detailed analysis of Balance of Payments and financial markets of many countries. All this means that this element is likely to have a neutral effect on stocks.
 
Debt loads and bubbles
The last element to look at is debt loads of households and firms. This is important because it is a fundamental recurring theme of the most severe crises, all the time: private sector credit increases and becomes excessive, inflation increases, interest rates increase, the rollover of debt becomes harder, asset liquidation starts, delinquency rates increase, and it all comes crashing down, bringing the whole economy and stock market with it, and you get a lost decade.
 
I won’t list the dozen or so indicators you can look at, because they literally ALL tell the same story. Don’t take my work for it – look them up yourself: household debt to GDP, household debt to income, debt service and rollover risk, bank reserves and capital cushion, business debt to profits or debt to income, delinquency rates, etc. What do ALL these indicators tell us for the USA? They tell us that there has been massive deleveraging of the private sector since 2008 and that the “purging of debt” period is bottoming out now, in 2016. Government debt has indeed exploded, but that poses zero systemic risk to the economy and stocks for the 2-year period going forward. Thus, debt and leverage data actually suggest a slight upside potential for stocks, because leverage can increase, even with a gradual monetary tightening.
 
Conclusion
All in all, there is very low probability of a major stock market collapse in the 1-2 year period going forward, with slight downside risk for the 0-3 month period until June, and slight upside potential after that, depending on developments in Canada and China.
 
I hope you enjoyed and that things are a bit clearer now! Cheers!