The market is normal about 95% of the time. But it’s the other 5% that makes or breaks you as an investor.
During normal times, macroeconomic concerns don’t really matter. Regardless of whether there’s a bull or a bear at the helm, you can safely forget about the U.S. Federal Reserve… short-term share prices moving up or down… the overall stock market’s valuation… housing… inflation… geopolitics… interest rates… the list goes on.
To succeed, you just keep buying, no matter what.
But when you look back over your investing career many years from now, you’ll realize that the normal times didn’t matter much, if at all.
It’s the other 5% of the time – the mega-bubbles and the busts that follow them – that define your investing career.
A mega-bubble is a period of frenzied speculation that takes the stock market to a rare valuation peak… before catapulting it into a brutal bear market that sends stocks plummeting 50% or more.
There have been only three U.S. mega-bubbles in the past century. One peaked in 1929 and led to the Great Depression. The second peaked in 2000. We refer to it now as the “dot-com bust.”
The third began in mid-2020… and despite stocks falling into bear territory this year, the data we’ll look at this month show we’re not out of the woods yet.
You might not believe it – but stocks are still in a mega-bubble. We’re still in that crucial 5% of the time. And just as it was in 1929 and 2000, the implication is crystal clear…
It is highly likely that you will make the most important investment decisions of your life starting right now and continuing for the next year or more.
Today, we’ll look closer at the current mega-bubble and what it really means…
We always pay more attention to the overall valuation of the stock market than to any other macro metric because it’s perfect for assessing risk and return prospects.
When valuation is high, future returns are low and risk of a downturn is high. That’s just simple arithmetic. If you pay $100 for a bond that pays $10 interest, you’ll earn 10% while you hold the bond. If you pay $200 for the same bond, you’ll earn 5%.
It’s the same with stocks, except that the returns come from the company’s earnings, not from interest payments. And earnings don’t stay the same. They can grow or shrink.
To track the overall stock market’s valuation, we use the S&P 500 Index’s price-to-sales (P/S) ratio, which consistently correlates negatively with subsequent 10-year and 12-year returns. That means when the P/S is high, subsequent returns are low, and vice versa.
The P/S hit an all-time high of 3.18 on December 31, 2021. That was the most expensive moment for the U.S. stock market in recorded history. In other words, the mid-2020 bull run is the most overvalued mega-bubble of all time.
The S&P 500 peaked on January 3, 2022 and has fallen as much as 25% since. At recent levels, the index trades at around 2.2 times sales – just slightly below the peak at the height of the dot-com mania in March 2000. Take a look…
The bear market has only just begun, and U.S. stocks are still in mega-bubble territory.
So how much farther could they fall?
We can’t know until after the bear is over. But it’s worth considering past mega-bubble bear markets to get some idea of what could lie ahead…
In addition to the three U.S. mega-bubbles in the past century, there was also a mega-bubble in Japan that peaked in 1989. And although the U.S. housing bubble hadn’t hit “mega” territory when it burst in 2007, the ensuing bear market did take the S&P 500 down 57%. So we’ll include it in our discussion.
Mega-bubble bear markets tend to be long and brutal. The Japan bear market is an outlier at more than 8,000 days (nearly 23 years!), but others have lasted roughly 500 to 1,000 days (about 1.5 to three years).
As we’re roughly 300 days into the current bear, history suggests it will be another 200 to 800 days until we hit a bottom. Take a look…
Nick Reece – the vice president of Macro Research & Investment Strategy at Merk Investments – recently posted a chart on Twitter, which showed several bear markets broken into thirds based on longevity. He determined that “bear markets tend to be backend loaded.”
That means the biggest losses tend to come in the final third of the bear market. Here’s Reece’s data for two U.S. mega-bubbles and the housing bubble…
My mantra for the past few years has been, “Prepare, don’t predict.” Predictions are generally a waste of time. It’s more productive and important to prepare yourself for a wide range of outcomes and to spell out how and maybe even why they might occur.
Reece’s results shouldn’t be taken as a prediction of the length of the current bear market… but they can help us prepare for what’s to come.
Good investing,
Dan Ferris
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Source: Daily Wealth