This Is Why The Stock Market Is Crashing

April 4, 2018

This Is Why The Stock Market Is Crashing

  • I’ll discuss the short-term perspective on what is going on, and the long term.



Introduction

I’ve been writing about the risk the stock market carries forever now. However, nothing was really happening until the last two months when volatility spiked and stocks actually went below their all-time highs.

Figure 1: S&P 500 year-to-date. Source: CNN Money.

The figure above shows us how volatility has increased and the daily sharp up and down moves tell us the market is looking for direction. Now, there are two ways to look at what is going on. One is the short term way that looks for clues about what pushed stocks down 3% on Monday, while the other is the longer term perspective that has helped Buffett to amass $116 billion in cash on Berkshire’s balance sheet.

Figure 2: Buffett has been piling cash for 4 years. Source: Bloomberg.

So, let’s discuss the short-term view first and then the long term view.

Short Term View On The Stock Market

Since the market peaked in January, investors have gotten jittery about what’s going on amidst fears of trade wars, tech regulation, and higher interest rates driving the economy into a recession. The sad thing is that their fears are well founded.

Why did stocks start declining in January and not earlier? Well, most investors don’t look at fundamentals but look at factors that will push stocks higher. So we have to look at what pushed stocks higher in 2017.

The answer is simple, higher earnings growth thanks to lower taxes and higher expected earnings. The market always prices in what will most likely happen, so 2017 was about pricing in what would happen in 2018 so that now, suddenly, the market has nothing to look forward to as a catalyst to push stocks higher like it did in 2017.

What doesn’t help are higher interest rates because those work like gravity on asset values as the values you compare investments with are lower thanks to better opportunities elsewhere.

Figure 3: The 2-year Treasury rate has been rising steadily for two years. Source: FRED.



Many investors compared the 2016 2-year Treasury yield of 0.8% to the S&P 500 dividend yield of 2% and stayed in stocks especially as stocks were expected to go up. Now in 2018, there is nothing there to push stocks higher, plus gurus like Ray Dalio say there is a 70% chance for a U.S. recession by 2020. And suddenly the 2% 2-year Treasury looks much more attractive than stocks that can easily fall 20% or more.

Regulatory jitters over tech, from Facebook to Amazon being accused of unfair activities, certainly don’t help stocks as tech companies have the largest weight in the indexes. Also, the S&P 500 finally declined below the 200-day moving average which is something lots of traders watch and has been a technical indicator for a while now.

Figure 4: The S&P 500 200-day moving average. Source: Yardeni.

That’s the short term, let’s take a look at the long term.

Long Term Perspective On Stocks

If you take another look from when Buffett started piling cash, it was the begin of 2014. It was exactly when valuations spiked and fundamentals didn’t matter anymore.

Figure 5: EBITDA acquisition multiples for U.S. companies. Source: Bloomberg.

Buffett knows that valuations come down sooner or later—be it as a long term trend or a crash—and he knows that if he is patient with his money, he will get the best long term investing opportunities. Many will look at stocks now and wonder how the stock market can crash 3% in a day, but the thing we should wonder about is how can a stock market index go up 64% over 5 years when the economy has only been growing at 2% per year.

Figure 6: S&P 500 growth over the past 5-years. Source: CNN Money.



I wouldn’t be surprised to see stocks fall to the 1,700 level and hear that Buffett is buying this or that. However, if the S&P 500 falls to 1,700, thus just where it was 5 years ago, there would be so much pain and capitulation selling from those who were still teenagers or not investing at all in 2008 who don’t even know what a bear market is that we could see much lower dips. Don’t forget that just $30 million of ETF and index fund outflows in one week crashed the index by 5% two weeks ago.

In the short term, stocks will be looking for direction. Earnings are coming up and might give a positive push but the fundamentals, the long-term fundamentals, are expensive, especially in a rising interest rate environment. Thus, be careful with what you do, don’t risk what you need (retirement fund) for something you don’t need (another 15% return from stocks) in the next 2 years.

What the market could also be pricing in is the end of the economic cycle which is something we will discuss tomorrow.