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An "Extreme Warning" From Our Doom Index

Jan 19, 2018

27

BALTIMORE - When we left you yesterday, we were describing why the situation is getting dangerous for investors, and how the lessons learned over the last 30 years may backfire in the next crisis.

"Dow over 26,000... bitcoin under $10,000," reports this morning's news... "but could crypto panic spill over into stocks?"

Investors are accustomed to depending on the Greenspan-Bernanke-Yellen Put... which is to say, they are pretty sure that the feds will come in with more booze when the party starts to flag.

"Buy the dip," they tell each other, confident that the feds can be counted on in a pinch.

Many think the recently passed tax bill is 80-proof, too - sure to rev things up by putting more money in the hands of shareholders and consumers.

Maybe it will raise stock prices. Or maybe it won't. What it won't do is make the next crisis disappear.

Bad Tidings

We hate to be the bearer of bad tidings, but bad tidings are all we have to bear.

Corporate America is already pretty flush. The price-to-earnings (P/E) ratio for the S&P 500 is now 70% above its long-term average.

In fact, the price of stocks relative to earnings has only been near this high three times in the last 118 years... each time caused by the aforementioned Fed party favors.

And if stocks go higher, it merely gives them further to fall.

In order to get back to more traditional levels, notes Martin Feldstein in yesterday's Wall Street Journal, the next bear market would have to wipe out some $10 trillion of stock market wealth.

This, he says, would take 2% off annual GDP... tipping the country into recession.

Extreme Warning

How close is this crisis?

We turn to our Doom Index, put together by our ace researcher, Joe Withrow:

  • The Doom Index spiked back up to "7" this month - our extreme warning level.

    After a surprisingly expansive third quarter in 2017, credit growth fell back to 1.6% in the fourth quarter. Paraphrasing your friend and economist Richard Duncan, bad things happen when credit growth falls below 2%.

    Looking at the credit markets, corporate bond downgrades continued to come in at an elevated level last quarter. And junk bonds are starting to show some cracks, falling more than 1% on the quarter. That said, junk bonds still closed out 2017 in positive territory.

    Stock valuations are still high relative to their historical averages. But we still haven't really seen the spike in "animal spirits" that we usually see at the end of each bull market.

    But that is starting to change. Investor bullishness spiked by more than 20 percentage points last quarter, as measured by the American Association of Individual Investors survey that we follow.

    Our financial metrics were the first to scream warnings at us back in 2000 and 2007... but the markets did not crash until we started to get warnings from our productivity metrics also. I suspect that will be the case this time around as well... But you can never know for sure.

    What you can know, however, is that we are much closer to doom today than we were last quarter. Might be a good idea to dust the old Crash Alert Flag off... Make sure it looks presentable.

Inevitable Bear

We've hung out the old black-and-blue Crash Alert flag so often - and without effect - that both it and our reputation for market timing are in tatters.

We're reluctant to expose either to further ridicule now.

But a bear market is inevitable. We recall the 1970s...

It was in 1973 that the Dow first crested above 1,000. Then, it went down... and didn't get back to 1,000 for another decade.

During that time, the '70s, "nominal" stock prices - without accounting for inflation, that is - went down, but never by more than about 25%.

The damage didn't seem so bad. But consumer price inflation was also steadily eating away at "real" (inflation-adjusted) values. You can see what really happened by looking at the Dow in gold terms.

The peak occurred in 1965, when it took about 25 ounces of gold to buy the Dow stocks.

Then, stock prices fell... down... down... down - to the point where you could buy the entire Dow with a single ounce of gold.

In real terms, stocks had lost 96% of their value.

Ready... Aim... Fire!

We see a similar debacle coming. The Dow sells for 20 times the price of an ounce of gold - below the level of '65, but higher than the level of '29.

Central banks are raising rates. Inflation seems to be picking up. And the feds have huge deficits to finance.

The bond market is going to be squeezed between more supply and less demand. Bond prices will fall as yields rise. Yesterday, yields on the 10-year Treasury rose to 2.58%, up from a low of 1.40% set in July 2016.

Stock prices will fall, either because of rising interest rates... or in spite of them. Expect initial losses of about 50%.

Then, once again, investors will turn their lonely eyes to the Fed.

Ready... aim... fire! The artillerymen at the Fed will give the order. But the shot won't be heard all around the world. Instead, it will barely be heard at all... because the Fed is out of powder.

As Mr. Feldstein explains, the Fed waited too long to begin raising rates. In a crash, it will want to cut rates. But unless the crisis waits another two years, it will have almost no rates to cut... and no monetary stimulus to offer.

What about fiscal stimulus, you ask - more deficit spending by the government?

Ah-ha... that's what the tax cut is supposed to be. In effect, while the Fed was too late... Congress fired its cannon too early - even before the enemy appeared on the scene.

And now, when the next crisis arrives, it will be almost impossible to pass another tax cut or spending increase... or finance more deficits... without driving up rates and making the situation worse.

But wait... what's that? Reinforcements!

Tune in tomorrow.

Regards,
BILL BONNER Founder, Agora Inc
Bill

Bill Bonner is the President & Founder of Agora Inc, an international publisher of financial and special interest books and newsletters.

Disclaimer: The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and have not been authenticated by any statutory authority. The author and Equitymaster do not claim it to be accurate nor accept any responsibility for the same. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. Please read the detailed Terms of Use of the web site.

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