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Why Stocks Could Drop 40%

Apr 18, 2018 | Fred Abadi |

Why Stocks Could Drop 40%

The impact of the Trump administration on the US stock market is significant. A looming trade war with China and policy proposals on the regulation of large Internet companies have led to a volatile marketplace, with added tension due to the Federal Reserve’s changes to its monetary policy.

Just how deep the stock market could fall depends on which of three scenarios we are likely to experience. Either way, investors should expect further unrest on the stock markets.

Nicholas Colas, cofounder of DataTrek Research, says that they “are not expecting a US equity market crash [but that] there’s no sense in denying the obvious—US equity markets feel shaky. He sees three possible scenarios:

  1. A sudden crash with a significant drop in a short period.
  2. A slow-motion train wreck” with smaller daily losses over a longer period.
  3. A “catalyst-driven price reset,” as investors fear a potential recession.

A sudden market crash

According to Colas, a rapid crash may not be as bad as it sounds. After 1987’s Black Monday, which is still the single-largest one-day percentage drop in Dow Jones’ history, the markets still recovered by 10% at the end of that year.

Colas calculated that the S&P500 had a forward price-to-earnings ratio (P/E) of 9.9 at the close of Black Monday while the US 10-year Treasury not yielded 8.9%. The total—18.2—could be used to measure the valuation of the two markets, he says.

The current 10-year yield is roughly 2.8%, and the S&P500 P/E would need to drop to 15.4 (currently, it’s around 16) to arrive at the same valuation. For that to happen, the S&P would need to drop to 2,187—a “1987-style low,” according to Colas. Currently, that would equal a drop of 16%, enough to push investors to further sell off their stocks.

A slow-motion train wreck

The cyclically adjusted price-to-earnings ratio (CAPE) compares corporate earnings and stock prices over the past decade. The current CAPE of the S&P500 is 31.88. This number is almost double the mean reading of 16.8 (going back to the 1880s) and only exceeded by the dot-com era.

To reach the historical average, the S&P500 would need to drop by a stunning 36.8% to 1,646. However, Colas doesn’t see this as a likely scenario and says it would take up to 18 months to fully play out.

A price reset

In Colas’ third scenario, stocks are discounted in anticipation of a recession within a two-year period. About this scenario, Colas says that it “feels the most logical right now, if only because the US Treasury yield curve continues to flatten.” The yield curve plots yields across all Treasury maturities. As we discussed in a previous article, about the treasury yield, debtholders typically demand a premium (a higher yield) for Treasuries with long maturities, so the curve usually goes upwards. A flattened curve, on the other hand, is a sign that investors have a less optimistic outlook.

According to DataTrek, corporate earnings are typically reduced by an average of 20-30% during a recession. If the multiple of the index stays the same, a 20-30% drop would land the S&P’s value between 1,776 and 2,106. To reach the middle of that range (1,941), the S&P would have to drop by 25.5% from last week’s closing price.

Colas emphasized that neither of the scenarios represent DataTrek’s base case but that it “makes sense to plan, if only to understand the downside through the lens of preparation rather than the rear view mirror of regret.”

Diversifying your portfolio and adding a portion of physical precious metals will protect you from any of these scenarios. Ask us about our free guide to help you learn how you can protect and grow your wealth today.