These Will Be The Causes Of The Next Recession

April 9, 2018

These Will Be The Causes Of The Next Recession

After a long period of stillness, we are finally seeing two-way markets which is a clear indication that the market is looking for direction.

Last week we saw two days with drops larger than 2%, and the so called Kudlow rally on Wednesday.

Figure 1: S&P 500 index last week. Source: CNN Money.

After such a long period of low volatility, the increased volatility means that the market is testing the new trend. If we actually see the U.S. make a deal with China that benefits both sides, we might actually see the market pass the current test and rally higher. However, if the current volatility doesn’t pass the test, we could see the market at much lower levels.

What’s crucial to understand here is the difference between a trigger and a cause which is best explained by using the first world war example.

In 1914, the archduke Ferdinand of Austria was killed in Sarajevo by a Serbian terrorist. Austria declared war on Serbia, which was an ally with the English who then declared war on Austria and the first world war began.

So this was the trigger, but it wasn’t the cause of the war. The causes of the first world war were militarism, alliances, imperialism, and nationalism. Most countries had been heavily investing in military power before the war and the antagonism was high. It’s important to note that prior to the war, there were other crises like the Moroccan crisis where war almost broke out.

A similar approach can be used on the stock market and the economy.

There are triggers that make the market go up and down like it did last week, and there are the actual causes. Let’s see the triggers could be of a recession and stock market crash, and what the actual causes would be.

The first trigger could be tensions between the U.S. and China, which is also what the media likes to mention.

Figure 2: Wall Street Journal describes how stocks plummet. Source: Wall Street Journal.

However, a while ago, the trigger would have been North Korea. Before that in 2016, it was the fear of a global recession due to a slowdown in China. Other noise is a possible war between Iran and Saudi Arabia.

Now, the actual cause stocks are down 8% and are volatile isn’t the trade war, it’s the fact that stocks have been going up for 9 years now and are up 25 times over the last 35 years, valuations are stretched, and it’s easy to see negative news push stocks down.

Further, stocks can’t stay flat because that isn’t in our nature, at least not in the nature of 99% of investors. Stocks either go up or down in shorter or longer periods of time. This shows how irrational markets are and how markets are driven mostly by sentiment. Sooner or later, that sentiment changes and it’s important to watch for triggers but also understand the causes in order to better analyze the risk reward.

The Causes Of The Next Recession & Stock Market Crash

Apart from the fact that stocks have been going up for 35 years now, economic fundamentals show the party will have to stop at some point.

The key to economic growth is productivity growth and whatever we see above that in the form of economic growth is only thanks to debt.

Figure 3: Productivity growth in the U.S is at low levels. Source: Bureau of Labor Statistics.

If productivity is low, the only way to spur economic growth is through debt and the public debt to GDP ratio has increased 3 times over the last 35 years.

Figure 4: Public debt to GDP ratio. Source: FRED.

Valuations have also never been so high in history as in the last 20 years, not even in 1929. So a reversal to the mean for valuations would also be a cause for a big bear market.

Figure 5: S&P 500 PE ratio since 1871. Source: Multpl.

And the final cause for the next crash and recession are interest rates, which simply work like gravity on the economy and asset values.

Figure 6: Interest rates can go up, but also down over the long term. Source: FRED.

So, there are triggers and causes. Keep an eye on both and you will know what to do from a life cycle investing perspective.