Stock Market Crash of 2016 – Investor discretion is advised…

The MSCI World equity index hit its lowest level since June of 2013. The index has already dropped approx. 11 percent in January, which if sustained in the next 10 days, would put it on course to be the worst monthly loss since October 2008. The index is down 20.5 percent from its high in May, confirming a bear market, which is loosely defined as a drop of more than 20 percent.

It seems like this market cycle could end up being called the ‘Stock Market crash of 2016’ or worse, and end up worse than the one in 2008. Read on to understand why this may be the case.

It is fair to say that a majority of the governments and central banks introduced considerable monetary and fiscal easing to stabilize the stock market during the ‘Great Recession of 2008, which served to not just lift it off the lows, but to create new all-time highs in equities and other asset classes as well. Arguably, this unprecedented action by governments and central banks caused a bubble to be perpetuated at least in certain asset classes.

Over the last few months, a confluence of factors have come together to create what seems like a “perfect storm”:

US

1. Stronger dollar hurts US companies, suggesting lower earnings in Q4 2015 and in 2016.
2. US stock market is overvalued – P/E ratio of 21 at the end of 2015 is higher than the long-term average of 17. Just as P/E ratios overshoot on the upside during the boom years, they tend to undershoot during the down years as well. This suggests a drop of well over 20%, in addition to drop in earnings itself during a downturn / recession.
3. Michael Pento in an article argues that the long-term average of the market cap-to-GDP ratio is around 75, but it is currently 110, and that “the rebound in GDP coming out of the Great Recession was artificially engendered by the Fed’s wealth effect. Now, the re-engineered bubble in stocks and real estate is reversing and will likely cause a severe contraction in consumer spending”.
4. The sheer destruction of ‘wealth’ in individual sectors, and once-high-flying stocks (Apple – fall of over 30%, Twitter – fall of over 60%, Go Pro – fall of over 70% ), and even blue chip companies (Caterpillar – fall of over 30%, IBM – fall of over 30% etc.), in a short period of time, is stupendous.  One can argue that most investors and funds were blind-sided by the speed and intensity of the crash, and are still invested, suggesting there is more downside.
5. Slow growth – The U.S. economy likely did not finish 2015 very strong. The Atlanta Fed is projecting growth of 0.6% in the fourth quarter. Barclays’ economists forecast a lower 0.3% growth between October and December. If it is anywhere near those guesses, economic growth will be well behind last year’s fourth quarter figure of 2.1%.

China

1. Increased debt considerably over the last several years, taking it to upwards of300 percent of GDP in a very short period of time.
2. The renminbi’s falling value,crashing Shanghai equity prices (down 40 percent since June 2014) and plummeting rail freight volumes (down 10.5 percent year over year), point clearly to China growing much less than the stated 6-7 percent

India

1. Low and stagnant growth – stock market had arguably gotten way ahead of fundamentals, which of course has corrected by about 20% from its highs
2. Ecommerce valuations too high – Valuations of tech startups and e-commerce companies suggests there is a bubble, and several folks including Nikesh Arora of Softbank have hinted at this. Others have spoken of impending casualties and shakeout in this space.  The latest indication of this bubble is that e-commerce companies like Flipkart are still discounting heavily to entice the customer to buy, and continue to seek more capital
3. Huge amount of NPAs in banks’ books – How much banks are saddled with NPAs is anyone’s guess. Mr Rajan has promised banks infusion of 10 Bn $ capital over the next 4 years. Analysts estimate much more infusion is needed to adequately re-capitalize the banking sector.

Middle East

1. Oil-dependent countries will likely see huge deficits and may sell / draw down overseas assets running into hundreds of billions of dollars
2. Currencies of these countries have all depreciated substantially in the last few months.Canadian economy seems to be in big trouble and is staring at huge budget deficits. The Russian rouble hit new all-time lows Oil price plunge has caused Russia’s economy to contract since last year.

Oil & Commodities

1. Oil and commodities have fallen to below 2008 / 2009 levels, unexpected even by banking titans like James Gorman, CEO of Morgan Stanley. James Gorman called the extent of the oil price plunge an “absolute shocker”. Gary Cohn, COO of Goldman Sachs suggested that the oil drop was ‘confusing the market’ as it was a result of oversupply, and not demand drop-off.  Whatever the reason, what is clear is that the extent and speed of this decline has taken markets by surprise and inflicted enormous damage, and cascaded to other parts of the economy.

Debt

1. Cumulative debt levels (Government + Corporate + Household debt) in the largest economy in the world i.e. the U.S., has reached all-time highs
   • Household debt has increased back to its 2007 record of $14.1 trillion. Specifically, business debt during that time frame has grown from $10.1 trillion, to $12.6 trillion; the total national debt exploded from $9.2 trillion, to $18.9 trillion; and the Fed’s balance sheet has ballooned from $880 billion to $4.5 trillion.

Impact of Quantitative Easing & Loose Monetary Policy by central banks

1. Europe Quantitative easing – The ECB began buying government bonds in March 2015 to stimulate growth and inflation.  In 2014, the ECB cut one of its main interest rates below zero in 2014, the first major central bank to ever try such a move.  Subsequently, Draghi initiated an asset-purchase program worth about 1.1 trillion euros ($1.2 trillion). It was further extended to buying bonds.  The long-term effects of such unprecedented moves has never been studied or tested.  Today, Draghi came out indicating more stimulus by the ECB in March.  It does not seem likely that this addiction to monetary stimulus will end well.
2. The Fed raised its key interest rate in December and projected there would be four more rate hikes in 2016.  Interest rates were raised for the first time since the 2008 crisis in the US. Although, the Fed has not suggested so, it is expected that they will likely reverse course, or at least suspend it.

Moral Hazard

1. Anecdotal evidence suggests that, post government intervention in 2008/09, and at least a “seeming” return to normalcy over the last 7 years, a number of investors and funds were over-invested in various ‘risky’ asset classes including equities and real estate, perhaps as a result of a combination of low cost of capital, and the perception that governments and central banks would ensure their capital and asset values would be protected, a situation referred to by economists as ‘moral hazard’.

U.S. Presidential Elections

1. Finally, from recent memory,the last three times – around the time Presidential elections happened in the U.S. – there was a market meltdown (the recession of ‘91, the dotcom bust (2001), and Great Recession of 2008).  O’Hara, chief market technician at FBN Securities has studied this trend since 1920 and found a similar correlation.  Whether this was a mere coincidence, or if in fact there exists a strong correlation, is perhaps a matter of conjecture, and calls for an in-depth study by economists.

On the flip side of all this, the most common reason cited by experts to suggest we are in a far better situation that in 2008, is the ‘fact’ that banks are adequately cushioned by much higher capital.  While this is true, all it suggests is that should an economic shock like in 2008 occur, the banking system will not go bust.  This in itself does not however guarantee assets will not be decimated in value.  One only hopes that the ‘stress tests’ conducted genuinely tested the banks’ resilience to withstand economic shocks, both in terms of speed and intensity.

Meanwhile, RBS recently in a note to clients a week ago said, “Sell everything! 2016 will be a ‘cataclysmic year,‘ alluding to some of the same reasons mentioned here.  Fair to note that panic has set in, at least in certain pockets.

In our assessment, how the U.S. Fed talks and guides the market over the next few weeks and months, and the extent of control and impact that has on the stock, bond, commodity, and currency markets will determine where we go from here.  One is advised to use “extreme caution”, as we see a ‘Black dot’ in the horizon; whether it turns out to be a ‘Swan’ time will tell (Heard of the ‘Black Swan’ event in Stock market parlance ?).  Pushed to give an asset class to recommend from an investment standpoint, it has to be gold – the only asset class that has withstood the test of time in terms of protecting one’s investment.

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