Just yesterday, in a question and answer session on Reddit, multi-billionaire businessman and philanthropist, Bill Gates said that a financial crisis of the magnitude of 2018 is “a certainty”. He also mentioned that legendary investor, Warren Buffet is convinced of it as well. The question is why? Why reason would have our stock market crash again so harshly?
Most astute investors know that stock valuations are at or near historical highs, but that is not enough to justify a historical crash. Why won’t we have a simple market correction? Here’s a possible explanation to why Mr. Gates is so “certain”. In a published study done by Michael Lebowitz , the author shows that even these investors, however, may be unaware that today’s valuations, when adjusted for the level of economic growth and heightened profit margins, defy comparison with any prior period since the Great Depression. It can be easily claimed that when buying stocks, each dollar spent buys potential growth. When the purchase of stocks is based on a premise of growth that cannot be fulfilled, the investor is putting himself in harms’ way.
In a previous article (part 1 of this series), we showed the conclusive evidence that our national GDP growth is declining, so from a national perspective, investments done today, are buying a declining national GDP or less growth. This is one weak leg on which current investment stands. The additional leg of the argument that stock prices are inflated beyond what investors foresee, is corporate profit margins.
Corporate Margins are Cyclical
Corporate profit margins, or the difference between sales and net profits, are considered one of the most cyclical fundamental measures that exist. The reason is that, when margins are high in certain industries, new entrants are lured to those industries by the higher margins. Conversely, when margins are low, companies exit those industries and those remaining companies can increase margins. The graph below shows the cyclical nature of corporate margins since 1948.
When margins are higher or lower than average, it makes sense to assume they will revert to the average over time, which means they will go lower. Therefore, the author proposes to adjust the traditional price per earning of the stocks to the cyclical patterns of lower GDP and the potentially peak profit margins. The logic for normalizing Cyclical Adjusted Price per Earning (“CAPE”) based on current margins and its historical tendency, provides a valuation level, as shown below, that is comparable to other periods.
If you accept this methodology, the conclusion from the data available shows that investors are paying over three times the average and almost twice as much as the prior peak for a dollar of economic growth. Furthermore, it is happening at a time when we are clearly late in the economic cycle and the outlook for growth, even if one is optimistic, is well below that required to justify such a level. If this study is correct, then we are looking at a stock market “perfect storm” downturn which will be historic, rivaling the 80% stock price declines of the Great Depression. Is that what’s driving Bill Gates’ conviction?
Will a market collapse of the magnitude of the Great Recession of 2008, affect your retirement savings? will it risk your income? Do you know that when the stock market collapses, commodities rise? Gold and silver prices skyrocketed after 2008 going up 3 and 5 times respectively? Contact us and we can help you diversify and protect your wealth from this market crash “certainty”, or simply ask for our free precious metals investor guide to learn more about it.