After reaching fresh all-time highs in early January, the S&P 500 (NYSEARCA:SPY) has plummeted to the point where it is now flirting with bear market territory. In fact, earlier this month it officially breached the 20% off of highs metric that is used to officially label a bear market:
While a case can certainly be made that the market has corrected enough as each of these tech titans have strong cash flow generation and are still posting solid performance metrics with stellar competitive advantages and balance sheets, we think things could also potentially get much worse before they get better. In this article we will discuss four reasons why this could be the case.
Reason #1: Much Lower Interest Rates
One of the biggest ways that the Federal Reserve has fought past bear markets was by lowering the federal funds interest rates. This method has proven to be very effective because – as Warren Buffett likes to say –
Interest rates are like gravity in valuations. If interest rates are nothing, values can be almost infinite. If interest rates are extremely high, that’s a huge gravitational pull on values… The most important item over time in valuation is obviously interest rates. Low interest rates make any stream of earnings from investments worth more money. Any investment is worth all the cash you’re going to get out between now and Judgment Day, discounted back. Well, the discounting back is affected by which interest rates you use.
The federal funds rate is particularly impactful on the stock market because it is the interest rate that depository institutions charge each other for overnight loans and is also the main basis for determining the prime interest rate, which in turn influences mortgage loan rates, credit card rates, and many other business and consumer loan rates. As a result, whenever the Federal Reserve raises the federal funds rate, it is increasing the cost of money, thereby shrinking its supply. Lowering the federal funds rate has the opposite effect, increasing the monetary supply by reducing its cost.
This has a double-impact on the stock market. In addition to impacting the discount rate for determining equity valuations, it also impacts economic activity. Higher interest rates generally reducing consumer demand and increasing business debt servicing costs whereas lower interest rates generally increase consumer demand and reduce business debt servicing costs, encouraging them to borrow more to invest in expansion projects.
With this in mind, it is informative to note that in both the runup to the 2008 crash and the 2020 crash, interest rates were meaningfully higher than they are today:
What this means is that previous booms were being sustained at much higher interest rates than the current boom has been and that therefore the Federal Reserve had much more economic “ammunition” to combat those downturns by reviving the economy via dramatic interest rate hikes. In contrast, the current environment only offers the Federal Reserve very little room to stimulate the economy. In fact, the Federal Reserve is talking about raising interest rates meaningfully further, so the chance of an interest rate related stimulus to overcome the current downturn is very low at the moment. This means that the current downturn in the SPY could wind up being much worse and potentially much more prolonged than the last two.
Reason #2: Much Higher Inflation Rates
In addition to the interest rate related headwind, inflation also poses a major threat to the current economic situation that could also lead to this downturn being much worse and more prolonged than the last two.
Similar to interest rates, high inflation provides a double negative shock on the stock market as it often means that earnings for businesses are eroded via reduced consumer demand and lower profit margins while also pushing investors to seek high nominal total return potential from investments in order to generate real returns (i.e., net of inflation).
As an aside, it also has a very negative impact on the Federal Reserve’s ability to combat an economic and/or stock market downturn via cutting interest rates and printing money as those measures exacerbate inflation further. In fact, the Federal Reserve is working towards reducing the size of its balance sheet rather than expanding it further, meaning that expanding quantitative easing to reflate the economy is unlikely in the current environment. This means that the Federal Reserve’s hands are largely tied here, preventing it from doing much to combat the current downturn in contrast to the past two downturns when the government engaged in massive quantitative easing:
Reason #3: Greater Geopolitical Headwinds
It is no secret that geopolitical headwinds are greater today than they were in 2008. In addition to the war in Ukraine, the threat of war in East Asia, the Middle East, and potentially expanding into a global war or even nuclear war is perhaps higher than it has ever been since the end of the Cold War. Palantir’s (PLTR) CEO Alex Karp said the other day on CNBC that the chance of nuclear war is 20-30%, while Ray Dalio has repeatedly emphasized that we are transitioning into a new world order where conflict between the established great power (the United States) and the rising great power (communist China) is growing increasingly likely.
Meanwhile, we are still dealing with stubbornly persistent COVID-19 flare-ups in strategic locations such as Shanghai, China and the world appears headed for a food shortage due to fallout from the Ukraine war and lingering severe supply chain issues.
While 2020’s crash was pretty much entirely fueled by fears and uncertainty over the COVID-19 outbreak (which wound up being largely unfounded other than for the negative impacts from government lock down measures), the long-term headwinds from current geopolitical headwinds are potentially much more severe. In particular is the fact that soaring geopolitical tensions means undoubtedly reduced global trade and much higher government spending (i.e., taxes and inflation), placing serious long-term burdens on the major economies of the world.
Reason #4: Much Higher Valuations
Last, but not least, the valuations we are seeing today are much higher than they were in the lead-ups to the 2008 and 2020 crashes.
At its pre-crash peak in 2007, the S&P 500 traded at a P/E of under 19.42x.
At its pre-crash peak in 2020, the S&P 500 traded at a P/E of 23.16x.
At its peak before the recent pullback, the S&P traded at a P/E of 24.09x.
Furthermore, the Buffett Indicator – a metric that compares the U.S. Market Value to its GDP – well exceeded 200% on its recent pack, whereas it was in the neighborhood of 175% in early 2020 and just slightly in excess of 150% at its the pre-2008 crash peak.
The SPY has been on a tremendous run, combining low fees (currently expense ratio is just 0.09%) with high liquidity to amass at its peak over $450 billion in assets under management.
Index investing has become wildly popular with retail investors and SPY has given them little reason to look elsewhere, by roughly tripling investor money over the past decade while offering the most passive and liquid highly diversified investment vehicle on the planet.
However, with interest rates remaining near historic lows and very likely headed higher in the near term, inflation rates at four decade highs, geopolitical headwinds at multi-decade highs, and market valuations near historical peaks, index investors in SPY could be in for a rude awakening.
As a result, we are diligently working to build a portfolio of high quality dividend stocks – many of which have low correlation to SPY – in order to set ourselves up for potential outperformance in what could be some very rocky years for the S&P 500.