On the contrary, I have determined from studying various photographs of Michael Burry that he is approximately 5’8’’ (sarcasm). Here, “the Big Short” is referring to his portfolio as of November 15, 2022.
If you have been watching the stock market at all over the past year, you are probably aware that it has been crashing. As of December 19th, the NASDAQ is down about 33% from its highs, while the S&P 500, which contains the 500 biggest companies in the US by market cap, is down about 20%. This is a significant loss of value, to be sure, but I believe the market has quite a bit farther to go before it reaches a bottom. Furthermore, I think most of this falling will happen in 2023. Allow me to explain my reasoning.
There is a near infinite amount of data one can use in order to make predictions about the stock market and individual companies. It is easy to become overwhelmed, confused, and “lost in the weeds” of the veritable ocean of information. For that reason, I like to keep things simple whenever possible. And while it may be nearly impossible to predict day to day price action, long to medium term predictions can be made with a significant degree of accuracy.
There are four basic sources of information that I am using in order to make my prediction. They are:
- Increasing interest rates by US Federal Reserve Bank and other central banks
- The inverted yield curve of the bond market
- Price to Earning Ratios (P/E)
- Analogous bear markets and market crashes throughout history
1. Increasing Interest Rates
In an effort to keep the economy running strong during Covid lockdowns, the US Federal Reserve Bank and other central banks around the world increased the rate of quantitative easing and began pumping money into the economy while slashing interest rates to near zero. This was one of the main factors that led to the runaway inflation that we have been experiencing for the last year or so. To bring inflation back down to the target 2% mark, the Fed has been increasing interest rates on a monthly basis. This has the effect of increasing the cost of borrowing money, increasing debt servicing cost, and overall tightening financial conditions so that spending is reduced and the cycle that drives inflation is slowed. The federal funds rate is now at 4.3% and the target rate, while not known at this point, is thought to be around 5%.
When trying to measure the effects of these interest rate hikes on the economy, one will notice that there are significant lags between when the interest rates are raised and the effects begin to materialize. Up until only a couple of months ago, most economic indicators, like unemployment rates, continued to run red hot. Only now are we starting to see some substantial cracks in the economy. Considering that the fed isn’t done hiking rates and they have indicated their intention to keep the rate high “until the job is done”, it is safe to say the economic climate is going to get far worse, and there is high likelihood of a recession.
2. Inverted Yield Curve
A yield curve inversion occurs in the bond market when the yield (interest rate) of short-term (2 year for example) treasury bonds becomes higher than that of long-term bonds (10 year for example). In a normal, healthy economy, long-term bonds yield higher interest payments than short-term ones, because your money is tied up for a longer period of time. However, in periods of financial turmoil, this can become reversed, and this “inversion” has historically been a very reliable indicator of a recession. In fact, every time the yield curve has inverted in the last 47 years, a recession has followed shortly thereafter.
To understand why this phenomenon reliably predicts recessions, one must first understand how it is created. It is driven by two main factors: interest rates and investor psychology. As the Fed raises interest rates, the yield on short term bonds goes up as a direct result, because the new interest rate becomes the cost of borrowing, and bonds are a debt instrument – a means by which one party loans money to another. The second part of the equation, investor psychology, causes demand for long term bonds to increase, as investors take their money out of riskier assets and opt for safer long-term bonds, and this, in turn, drives the yield of long-term bonds down. So in sum, as interest rates rise, investors begin to ‘price in’ a period of short-term financial turmoil, and this phenomenon has been a reliable indicator of past recessions.
Above, we can see how the yield curve went from being healthy one year ago to inverted as of December 19, 2022.
3. Price to Earnings Ratios
Now that we’ve set the stage for a recession, let’s consider how this will likely affect equity valuations. There are many ways to value businesses, but since my philosophy is to keep things simple whenever possible, let’s look at price to earning ratios (P/E ratios) which compare the market cap of a company to its annual profit. P/E ratios are the foundation of business valuation; a P/E ratio of 10 or less is usually considered in “value” territory while a ratio over 20 can be indicative of either overvaluation or expected growth. In other words, if you expect a company to grow it’s earnings in the next couple of years by 3x, you might be willing to pay a high multiple for its current earnings; however, if this growth does not pan out, you may have overpaid and it will take a long time to recoup your investment.
The average P/E ratio in the S&P 500 currently is 19.79 while the historic average is 15.99. This indicates that it should, at the very least, return to the mean in the midst of a recession. Furthermore, many large cap tech companies are starting to see drops in revenue and earnings as the economy slows. If they are still priced for growth while their revenues and earnings are shrinking, what needs to happen? The answer is the stock price needs to fall.
4. Analogous Bear Markets and Market Crashes
The final source of information that I want to consider in support of my bear thesis are previous market crashes. History tends to repeat itself, so we can learn about what is likely to happen this time around by studying similar events from the past.
In March of 2000, the S&P Index reached a peak of $1527. It then spent the next two and a half years plummeting before finally reaching a bottom of $800 in November of 2002; that’s a loss of about 52% of its value. In the next market crash, the 2008 financial crisis, it reached a peak of $1561 in October of 2007 before bottoming at $683 in March of 2009, about a year and a half later. This time it lost about 56% of its value. Though these bubbles and subsequent crashes had different causes, they resulted in a similar loss of value in a similar amount of time.
Looking to another analogue, the “Black Monday” crash of 1987 happened in a much shorter period of time, only 3 months, but it lost a comparable 44% of its value by the time it bottomed. Considering, as I stated in the first paragraph, that the S&P 500 has only lost about 20% of its value so far (as of December 19th 2022), if it has indeed bottomed already, that would make it a far shallower crash than ones in recent history. When you consider these comparisons coupled with the number of headwinds facing the market currently, it seems very unlikely that we have reached a bottom.
A chart of the “Dotcom Bubble” and subsequent crash in the year 2000
What Should you Do?
If you have read the Intelligent Investor by Benjamin Graham – essentially the bible of “value investing” – you would have encountered Warren Buffet’s favorite passive investing strategy which is to simply buy into the S&P 500 Index and hold over a long period of time. Since the S&P 500 is made up of businesses that generate value, it goes up long term, so if you are willing to wait long enough, you won’t lose money. However, since the arguments I have presented show that the S&P 500 is likely to fall in the next year, a better strategy would be to sell it short over a short period of time. There are various ways to do this, but the simplest way is to buy shares of an inverse ETF that tracks it, for example the Pro Shares Ultrashort S&P 500, ticker symbol SH. There are also leveraged ETFs which will amplify returns (or losses) by 2x or 3x, but I do not recommend holding those longer than two months. For a list of some inverse index ETF’s, check out https://etfdb.com/etfs/inverse/equity/
One thing I have learned from observing the current market crash is that not all companies crash at the same time. Instead, highly speculative assets, like crypto, and fundamentally unsound companies crash first, while assets with real world value, like real estate, and fundamentally sound companies are the last to go. And, in fact, some companies may never crash; energy producers, for example, are doing very well recently. The big, fundamentally sound companies that I think need to crash are ones that appreciated rapidly in 2020 and 2021, obviously benefiting from the loose financial conditions. For example, Apple and Nvidia are two ‘blue chip’ companies that are now sporting unrealistic P/E ratios in light of their near-term growth prospects. Both are seeing revenues declining and this trend is likely to continue for the entirety of 2023 at least. Shorting these names, with a plan to cover within a year, would be a safe bet as of today, December 19, 2022.
I would avoid shorting any of the speculative names that have already lost ~90% of their value in the last year, depending on your appetite for risk. Although it is quite likely many such companies will continue to go down, some may see violent moves upward due to acquisition rumors or other factors.
Blind Optimism 