As US equities reach all-time highs, I can realistically see the S&P 500 falling to 1,559 within two years, down 35% from its current peak at 2,400.
US stocks are simply too expensive
This chart represents the Price to Earnings ratio for the S&P500, adjusted for inflation following the Schiller method (it would be meaningless without accounting for inflation). The higher the price to earnings ratio, the pricier stocks are relatively to company earnings. Today’s valuations will be reaching an all-time high if you excluse 1929 and 2001. When investing you usually want to buy low and sell high, so does it seem wise to buy into the market when stocks have only been more expensive than they are today in 1929 and 2008?
Interest rates can go nowhere but up (Fed funds rate)
Over the past decade, economic growth has been driven by historically low interest rates. Businesses have been able to borrow at unusually low interest rates, driving artificial growth and making investors shy away from bonds (who wants to make 2% a year on a 10-year government note when you can make 8% a year in stocks + 2% dividends?). However, the Fed is starting to tighten this policy and will inevitably rise yields, therefore making bonds more attractive to investors than overpriced stocks.
We’ve reached the Golden Ratio
The Golden Ratio is a number that comes up often in investing and stock trading (and explains many other things in life from the length of flower petals to the length of your arms relative to the rest of your body – Google it). It is equal to approximately 1.62 and is used in stock trading with the Fibonacci retracements and the Elliott waves theory. In principle, the peak of each new market cycle tends to be 62% higher than the previous peak (the golden ratio).
The S&P 500 peaked at 1550 on July 13, 2007. In theory, the next peak should be at 1550*1.62 = 2,515
This is only 5% away from the last peak at 2,400.
2017 or 2018 seem to be good years for a market correction.
You might think this is nonsense and that I might as well be using Pi or the square root of two to justify my predictions. However, the golden ratio is not a joke and is heavily used in algorithmic trading.
The Elliott wave principle also indicates that a market correction tends to go down to 62% of its peak value. In 2008, the market bottomed at 676.53 on March 9, 2009, down 56% from its peak. Similarly, in the 2002 bear market, the S&P 500 bottomed 49% below its peak.
Unemployment can go nowhere but up
Since the 1990s, there has been an inverse correlation between the unemployment rate and the S&P 500. The unemployment rate has hit a historic low of 4.7% as of December 2016, which means it doesn’t have much room to go down any further. And when unemployment rises, the maket usually goes in the opposite direction.
That said, it won’t crash right away
The S&P 500 might not crash for another 2 years, simply because markets never crash when you think they will. The VIX, measuring volatility, is at historic lows, while the market is being calm. A crash is usually preceded by an intense but short bull market that leads people to believe the sky’s the limit – until it’s not. It is likely the market will go up another 10% to 15% before tanking. We saw this happen in 1929, 2002 and 2008.
A few looming crises
In 2000, it was a tech bubble. In 2008, it was a real estate bubble that affected the financial industry. What will it be this time? There are a few macro-economic trends to look out for. Student debt is reaching all-time highs and defaults are rising. Changes in the economy and unemployment could make many people default on their student debt, much like home owners defaulted on their mortgages in 2008.
The retail industry seems to be doomed as well. Clothing brands and department stores like JC Penney and Sears teeter on the edge of bankruptcy and could potentially send thousands of employees into unemployment.
Robert Kiyosaki, author of the personal development book Rich Dad, Poor Dad, argues that the market will crash in 2017. His argument is demographic and has to do with baby boomers withdrawing money en masse from their retirement funds, taking money out of stocks and creating a shortage of demand.
Lastly, slowing economic growth has contributed to the rising Price to Earnings ratio of stocks all around the world. Stocks don’t seem to care.
Given the current valuations of US stocks and macroeconomic trends, common sense tells us that there is now more potential downside than upside for the S&P 500 in the short term.
Disclaimer… I am not an investment specialist, and will not accept responsibility if you lose money by following my advice.