How Far Could The S&P500 Index Fall In A Primary Bear Market?

February 10, 2018

Summary And Conclusion

30% to 45% assuming consumers remain rational and assuming commercial banks are able to cope with a possible increase in their levels of non-performing loans.

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The era of Artificial Intelligence will facilitate easier and lower cost ways of conducting existing activities but will not necessarily add to conventionally measured Gross Domestic Product. (GDP)

Flowing from Central Bank policies of easy credit and declining interest rates – which began to accelerate in the 1980s – debt at both sovereign and consumer levels is  at extraordinarily high historical levels when measured as ratios of GDP. Interest rates (the cost of money) are at extraordinarily low historical levels. Not long ago, in more than one country, interest rates turned negative. The Central Banks have run out of wriggle room in this area.

Additionally, since the emergence of the Global Financial Crisis (GFC), it has required a growing incremental issuance of fiat money by the Central Banks to achieve a dollar of incremental GDP. One result has been a collapse in the Velocity of Money (the rate at which the money supply turns over). So-called Quantitative Easing has become counterproductive because the growing incremental liquidity within the economic system has been driving up the price of assets such as equities, government bonds and real estate.

In an effort to maintain Economic Growth, the burden of responsibility has shifted from Central Banks to Central Governments. There has been an explosion of commitments to build/rebuild infrastructure and to expand military related expenditure/investment – which will serve to increase the ratio of sovereign debt:GDP yet further, as has been demonstrated in the Chinese economy since the GFC.

The 100 Year Charts of both the Dow Jones Industrial Index ($INDU) and the Standard & Poor 500 Index ($SPX) have reached a significantly overbought technical situation, and Price to Earnings ratios are at 100 year highs (ignoring the anomalies that manifested in the immediate aftermath of the GFC).

In this context, for the equity markets to continue rising to new heights will require a sea change in the human psyche. Assuming volumes of commercial trade continue at the same level and at the same selling prices, corporate profits will continue to rise as Artificial Intelligence facilitates lower costs of output. But the flip side of these lower costs will be lower employment – which is why the central governments are moving to invest in infrastructure and military.

A back of the envelope calculation reveals that, for the 90 year average of 15X P/E on the $SPX to be achieved, corporate profits will need to grow by 8% p.a over the coming five years.  But this ignores the cost of money. Assuming that the cost of money will be around 4% p.a. (the technically anticipated target level of the 10 year US Government bond in the foreseeable future) then, to invest today in the $SPX with the objective of receiving 8% p.a. return on one’s investment, the current level of the $SPX will need to fall by  around 17%.

However, if the average historical rate of investment return on equities of around 12% p.a. is to be achieved over the coming 5 years, then the current level of the $SPX will need to fall by around 30% - assuming corporate profits will grow by 8% p.a. over the coming five years, and that today’s Net Present Value of corporate earnings in five years’ time allows for a discount factor of 4% p.a.

By way of a ‘what if” question, if corporate profits only grow by an average of 5% p.a. over the coming five years, then the current price of the $SPX will need to fall by an amount closer to 45% assuming a 15X P/E ratio at exit, and assuming a discount factor of 4% p.a., and assuming investors remain rational.

Wild Card

All the above assumes that the commercial banks will not experience extraordinarily high levels of bad debts in the coming five years. In turn, this assumes that unemployment ratios remain fairly constant, and that capital losses can be absorbed by consumers without affecting lifestyles and their volumes of consumption.

Interim Conclusion

If a Primary Bear Market manifests, the $SPX can be expected to fall by a minimum of 30% - 45% from current levels, assuming investors remain rational and continue to live their current lifestyles

Question: What is the probability that the US (and global) equity markets will enter Primary Bear Trends?

Answer: Without becoming too technical, the charts are showing subtle signals that the Primary Bull Market has peaked. Technically speaking, we might experience a “bounce” up from the $SPX’s low of 2,581 on February 8th, 2018

Overall Conclusion

If the anticipated retracement fails to take the $SPX above a level of 50% of the fall from its January 26th high of 2,872.87  i.e meaningfully above a level of 2,726, then the probability of a Primary Bear Market emerging will be extremely high. Investors can expect a minimum fall of between 30% and 45% assuming the level of commercial bank bad debts remains manageable, and that investors do not panic.

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Brian Bloom

Author, Beyond Neanderthal and The Last Finesse

Tea Gardens, NSW, Australia

Author note: My two novels were written with the objective of looking beyond the current dysfunctional political climate - which has given rise to a rickety world economy, a clash of civilisations, extraordinary levels of pollution, climate change and extraordinarily high levels of hubris, corruption and toxic testosterone among society's leaders. 

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In 1933 President Franklin Roosevelt signed Executive Order 6102 which outlawed U.S. citizens from hoarding gold.