Shilling says...

Stocks could be poised for a big drop similar to the market’s decline during the Great Depression, according to financial analyst Gary Shilling.

In a CNBC interview, Shilling said the stock market could plunge between 30-40% over the next year as investors realize the economic recovery from the coronavirus recession could take longer than expected.

“I think we’ve got a second leg down and that’s very much reminiscent of what happened in the 1930s where people appreciate the depth of this recession and the disruption and how long it’s going to take to recover,” he said.

The S&P 500 plunged in February and early March as the coronavirus pandemic spread across the U.S., forcing businesses to shut down and lay off workers. Since mid-March, the index has rebounded roughly 40% as investors have become optimistic about the gradual reopening of the economy and policymakers have injected trillions of dollars of economic stimulus into the financial system.

Early economic data has bolstered the case for a V-shaped recovery, where the economy bounces back quickly from a steep downturn, yet some investors are still cautious as the number of coronaviruses cases in the U.S. continues to rise. Many Americans have missed out on the recent market rally, with record-high levels of cash sitting on the sidelines.

Shilling said the S&P 500′s comeback resembles its rebound in 1929, when stocks rallied after an initial crash. He warned history could repeat itself with the S&P 500 poised to tumble again like it did in the early 1930s after the severity of the Great Depression became clear.

“Stocks are [behaving] very much like that rebound in 1929 where there is absolute conviction that the virus will be under control and that massive monetary and fiscal stimuli will reinvigorate the economy,” he said.

Shilling, who is the author of several books including “The Age of Deleveraging: Investment Strategies for a Decade of Slow Growth and Deflation,” said the coronavirus pandemic will force consumers to remain more cautious about spending in the coming years.

“I think we’re going to see downward pressure on prices and that works to the advantage of Treasury bonds, which have been my favorite since 1981,” he said.

economy forecast - 2024

The Morningstar US Market Index has come thundering back since its late March nadir and is now down merely 7% year to date, even as the coronavirus pandemic persists. While many investors are wondering if the market is exhibiting irrational exuberance, we think the rebound has been broadly warranted, as we forecast a strong long-run recovery in the U.S. economy. We expect U.S. GDP to drop 5.1% in 2020 but surge back in 2021 and experience further catch-up growth in following years. By 2024, we think U.S. GDP will recover to just 1% below our expectations before the pandemic.

Is the stock market overvalued?

In recent columns, I have written extensively about the seeming ‘disconnect’ between the economic recovery (weak) and the stock market (strong). I won’t rehash those arguments here, but the overarching takeaway is that the stock market almost always moves well in advance of an economic and earnings recovery. If an economic recovery is expected to pick up steam twelve months from now, the stock market is likely to make its move today. In my view, that’s what we’re seeing right now.

An investor who accepts this argument may also wonder when the stock market is over-pricing a recovery. Or, simply put, when does the stock market become overvalued relative to future earnings and growth?

Many would say the stock market is already overvalued. On June 30, the forward P/E on the S&P 500 was 21.7x, which is considerably higher than the 10-year average of 15.1x. In fact, the S&P 500 has not traded at this high of a multiple since the late 1990’s, in the run-up to the tech bubble.1 Does this mean we’re in another period of “irrational exuberance”? I do not believe so, for four reasons.

1. The Fed Model Suggests Stocks Can Go Higher

Without getting too into-the-weeds, the Fed model is a way of valuing the stock market that compares the forward earnings yield (the inverse of the P/E ratio) of the stock market with the 10-year U.S. Treasury bond.

For illustrative purposes, let’s say the yield on the 10-year U.S. Treasury bond is 5%, and the forward earnings yield on the S&P 500 is 6%. In this case, an investor might do better with stocks, but may ultimately decide that the 1% difference is not worth the additional risk. If the yield on the 10-year Treasury is 1% and the earnings yield on the S&P 500 is 5%, investors usually choose stocks.

Today, the forward earnings yield of the S&P 500 is over 4%,3 and the 10-year U.S. Treasury bond closed the second quarter with a yield of 0.66%.4 When extra liquidity is looking for a place to go, and the choice is between stocks and bonds, stocks look far more attractive on a relative basis.

What’s more, all signs also point to the Federal Reserve repeating its post-2008 Financial Crisis playbook of leaving the federal funds rate near the zero bound for at least a few years. Historically, a forward P/E of 18x or 20x on the S&P 500 was viewed as fairly expensive, but at the same time, interest rates never been this low for this long. It was once outlandish to think the S&P 500 could trade at 25x forward earnings, but with the current interest rate outlook, it feels more possible than unlikely, in my view.

2. Tech Companies Make Money – Lots of It

The last time the S&P 500 traded over 20x forward earnings for a sustained period was 1997 – 1999, with the index topping out at around 25x.5 But looking back, we now know there were basically no earnings supporting tech’s astronomical rise. Today, tech companies are leading the way with sales growth, earnings growth, and arguably reshaping the modern economy as we know it in the process. The pandemic is accelerating these changes, in my view. Not the other way around.

3. The Very Worst of the Crisis is Behind Us

Cases of Covid-19 are rising, so there is no argument to say that the spread of the pandemic is improving. What has changed between April and today, however, is a better understanding of how to test, treat, and care for patients who become infected. There are also more hospital beds and medical supplies available to handle case surges.

From an economic standpoint, I agree that the longer this crisis drags on, the longer and more difficult the economic road to recovery will be. But at the end of the day, recessions end when economic growth begins – even if that growth is merely a trickle at first. In my view, the very worst of the economic crisis is behind us, and markets are looking ahead to what the economy could look like at this time next year.

4. You Really Cannot Fight the Fed and Fiscal Stimulus

The world has never seen this type of liquidity event before.

Drawing from lessons of past crises, the Federal Reserve and Congress acted quickly and decisively with extraordinary stimulus measures. This stimulus is not unique to the United States, either. Developed countries around the world and China are pulling the monetary and fiscal levers too, with total fiscal and monetary stimulus now amounting to approximately 28% of world GDP. When money supply growth exceeds nominal GDP growth, as is presently the case (by a long shot), this liquidity flows through the capital markets—pushing asset prices higher in the process, in my view.6

The stimulus may increase from here. In a congressional hearing at the end of June, Federal Reserve Chairman Jerome Powell and Treasury Secretary Steven Mnuchin both pledged to consider additional relief measures to support the economy as the pandemic drags on. It is difficult to make a bearish case when this ‘wall of liquidity’ looms in the backdrop.

Bottom Line for Investors

Considering the four reasons detailed above, in my view it is not outlandish to imagine a scenario where the S&P 500 trades at 23x, 25x, or even higher multiples. I am not declaring that the S&P 500 will trade at these valuation multiples – just that it could. If the S&P 500 were to trade at 25x 2021 earnings of, say, $160 a share, that would imply an S&P 500 at 4,000. In my view, this type of outcome is actually more possible today than it is unlikely.

-- Mitch on the Markets, 7/10/20

Nifty Fifty deja vu?

If you look deeper under the hood of the stock market, you’ll see that there is a significant dichotomy between bytes stocks and atoms stocks. The atoms are losing to the bytes, badly. If you compare performance of the S&P 500 (SPY) traditional market-capitalization index – the one you see in the news – to its less-known cousin, the S&P 500 equal-weighted (RSP), you’ll see a significant disparity in performance.

In the market cap-weighted version, the top five stocks (all five are members of FANGAM gang – Facebook (NASDAQ:FB), Amazon (NASDAQ:AMZN), Netflix (NASDAQ:NFLX), Google (NASDAQ:GOOGL), Apple (NASDAQ:AAPL), Microsoft (NASDAQ:MSFT)) now represent 21% of the capitalization of the index (the last time this happened was 1999) and thus account for 21% of the returns. In RSP these stocks have a weight of 1% (they’re just 5 out of 500 stocks).

Just as any propaganda needs a certain germ of truth to grow from, so do bubbles. The FANGAM are incredible companies (germ of truth), and they function better in the virus-infested world (another germ of truth). But at the core, their existence is grounded in the world that is built of atoms, not bytes.

The Nifty Fifty stocks come to mind here. Those were the fifty stocks – the who’s who of the 1960s –that made America great (then): Coca Cola (NYSE:KO), Disney (NYSE:DIS), IBM (NYSE:IBM), Philip Morris (NYSE:PM), McDonald's (MCD), Procter & Gamble (PG) … the list goes on. Though today we look at some of them as has-beens, in the ’60s and ’70s the world was their oyster. Coke and McDonald's were spring chickens then, spreading the American health values of diabetes and cholesterol (okay, maybe I’m being too hard on them) across this awesome planet.

Although it was hard to imagine in the ’70s that any of these companies would not shine forever, they are a useful reminder that even great companies get disrupted. Avon (AVP), Kodak (KODK), Polaroid, GE (GE), Xerox (XRX) –all were Nifty Fifties, and all either went bankrupt or are heading towards irrelevancy.

In the 1960s and early 1970s these stocks were one-rule stock – and the rule was, buy! They were bought, and bought, and bought. They were great companies and paying attention to how much you paid for them was irrelevant.

Until.

If you bought and held Coke or McDonald's in 1972 (or any other Nifty Fifty stock), then you experienced a painful decade of no returns; in fact, at times you were down 50% or more. Coca Cola was as great a company in 1974 as it was in 1972, but the stock was down 50% from its high. Okay, Coca Cola was trading at 47 times earnings in 1972. But even a company like Procter & Gamble that was trading at “only” 32 times earnings in 1972 was down almost 50% in 1974 from its 1972 high. It took until the early 80s – a decade – until investors who bought Nifty Fifties at the top broke even – and this applies to almost all of them.

Another issue: If you held many Nifty Fifties for 20 years, from 1972 to 1992, they would have delivered a decent (10%-plus) return. This sounds great in theory; however, most people would have run out of patience after a decade of no or negative returns and thus not have been around for the fruits of the ’80s decade. In other words, shareholders who bought the stocks in 1970 were not the ones who benefitted from the returns in the late ’80s.

Today the Nifty FANGAM has turned into one-rule stocks – buy! (irrespective of price). If you did not own them over the last decade, your portfolio had an enormous headwind against it.

But what the Nifty Fifties showed us is that company greatness and past growth are not enough. Starting valuation – what you actually pay for the business –matters. The great companies will still be great when their stocks are down a bunch and they have a decade of no returns. Dividends aside, stock returns in the long run are not just driven by earnings growth but by what the price-to-earnings does as well. If price-to-earnings is high, it’s mean reverts – declines – chipping away at the return you receive from earnings growth.