The Biggest Bubble in History Is Bursting... Right Now
Editor's note: More pain is on the way...
With sky-high inflation keeping the costs of goods and services elevated, consumers have been feeling the weight of the Federal Reserve's onslaught of interest-rate hikes. But with the central bank determined to combat inflation through interest-rate hikes, inflationary pressure will continue to weigh heavily on the markets...
That's why Extreme Value editor Dan Ferris says it's crucial for folks to recognize that we're in a massive asset-price bubble that's about to burst...
In today's Masters Series, adapted from the July issue of Extreme Value, Dan evaluates the state of today's bear market... discusses what's causing this ongoing chaos... and explains why what we're seeing now is different from anything we've ever seen in the history of the market...
The Biggest Bubble in History Is Bursting... Right Now
We're officially in a bear market.
Bulls and bears come and go. It's a natural part of investing. And for investors focused on long-term value, downtrends – even significant ones – are welcomed events. They take the edge off inflated markets, strip out the riffraff, and result in many extraordinary opportunities to scoop up high-quality companies at huge discounts.
But this is no ordinary bear. This is the end of the world as we've known it for decades.
Ignoring this fact is the biggest mistake most investors are making right now. Fully understanding and preparing for the realities of the current bear market could be the difference between earning a decent return over the next few years... and a total wipeout of your savings.
The following quote from one of my recent Stansberry Investor Hour guests – friend, author, and master investor Vitaliy Katsenelson – shows you an easy way to avoid this mistake...
"Whatever happened to you over the last 20 years, just invert it."
See, as I told Stansberry Digest readers recently, the past 20 years saw steady trends of falling interest rates, climbing housing prices, soaring stock market valuations, and a growing economy.
Today, it's the opposite... Interest rates are rising, the stock market's overall valuation has tanked (and yet is still very expensive by the most reliable metrics), and the economy is shrinking in inflation-adjusted terms.
Here's the list of items I published in the Digest to try to orient readers to this new reality and help them say goodbye to the old one. (You might print this out and tack it up near where you do most of your investment reading and research. It's hard to keep all this stuff in mind, but two years from now, you'll be glad you did.)
I'm not saying these trends will hold 100% of the time for the next several years. I'm saying times have changed, and we need to adapt in order to overcome what's in store.
First, let's see what's causing us to have to invert the lessons of the past few decades...
We begin by recognizing a single, simple historical fact...
The biggest bubbles in the history of the financial markets did not end with anything like a six-month, 24% drawdown of the S&P 500 Index or an eight-month, 33% drawdown of the Nasdaq Composite Index – like what we've seen so far this year. That means that moving forward, more downside is likely and calls of a bottom are premature.
We'd all love it if there were a precedent for escaping a massive asset-price bubble without having to endure a huge bear market, but it doesn't exist.
After a huge equity bubble, the bear market tends to be long and the decline from peak to trough tends to be huge. Here's a snapshot of the biggest equity bubbles of the past 100 years bursting...
In other words, the bottom is nowhere in sight.
Within each bear market, there are incremental rallies. Last month, we noted how these bear market rallies tend to be smaller at the beginning of the cycle and larger near the end. So far, the biggest rally in the S&P 500 since it peaked on January 3 has been the 11% rise from March 14 to March 29. More recently, the S&P 500 rose 6.7% from June 16 to June 24 in a typical smaller, early bear market rally.
Those are normal rallies that occur naturally within every bear market. Unlike what many investors and financial media pundits are saying... they do not mark a bottom.
History suggests this bear market will last roughly between one and a half and three years. Since we at Extreme Value have a higher-than-average tendency to consider extreme outcomes that other investors view as unlikely and a waste of time to even consider, we've been warning you about and recommending you prepare for a difficult market for more than a year.
Since we've now been vindicated, let's continue to buck the trend and consider a simple mental model for thinking about the likelihood of extreme market outcomes: high-water marks.
Perhaps you've been to a place like Harpers Ferry, West Virginia, a small town that sits at the confluence of the Potomac and Shenandoah Rivers. Among the historical sites, you might notice the high-water marks showing the level of various floods throughout the town's history.
High-water marks are deceptive. They make you feel that they're unlikely to ever be exceeded. In fact, the opposite is true. The presence of multiple high-water marks in places like Harpers Ferry proves they're virtually guaranteed to be exceeded.
"Even the very highest one?" It's tempting to ask. Yes, that's the point. Each mark was the highest-recorded flood level in history... until an even bigger flood came along to claim the No. 1 position. If you view the latest high-water mark as an unattainable extreme, you're simply being fooled by randomness.
It's like that in financial markets, too. As we've pointed out, history can be an excellent guide in preparing for various possible future outcomes. But every now and then, modern markets exceed history's high-water marks, and we just have to wait and see how far the waters rise this time.
This holds true for both bull and bear markets. We didn't know how high or how long the bull would go before it ended, and we don't know how low or how long the bear will go before it ends. The last bull – the most overvalued, highly speculative market in history – reached unprecedented heights. It's reasonable to assume the bear that follows could become the most devastatingly deceptive and ultimately destructive one in history.
After this bursting bubble exceeds the last high-water mark and shocks everyone with its relentless brutality, nobody will want to own stocks when they finally hit bottom. An entire generation of investors that thrived off "buying the dip" will see much of their life savings wiped out and will swear off stocks. Many of them will never return to the market. (The same will happen in bonds – which are arguably in a bigger bubble than stocks – and crypto.)
That is what the bottom of a massive bursting bubble feels like...
For the first time in history, the U.S. is experiencing a confluence of three macro extremes all at once:
- High government debt to gross domestic product, like the post-war 1940s
- Excessive stock market valuation on par with the 1929 and 2000 bubbles
- A resource-driven inflationary crisis environment comparable with the 1970s
And though I've said it many times, it bears repeating that six months ago, stocks were more expensive than ever before by one reliable measure...
The S&P 500 price-to-sales (P/S) ratio is the easiest and one of the best ways to understand the overall stock market's valuation. When it's at extreme highs or lows, it's signaling heightened risk or opportunity.
Never in recorded history had the P/S ratio traded above 3 times sales... until April 2021. It then stayed at that extreme level – peaking at an all-time high of 3.17 on December 27, 2021 – until January 2022. Around 2.3 as I write, it's slightly higher than the dot-com peak, which was previously the most overvalued moment in history.
And in January, the cyclically adjusted price-to-earnings (P/E) ratio of the S&P 500 (or the Shiller P/E ratio, named after economist Robert Shiller) hit its second-most expensive level since 1870, the highest being the dot-com peak in early 2000. It has fallen with the market but is now right at 29, near its third-highest level of the past 150 years. It first reached this level in 1929 and didn't exceed it again until 1999.
In short, the stock market is not just extremely expensive. It's still valued like one of the three biggest equity bubbles in U.S. history.
In addition to the unprecedented constellation of macro forces, a huge turn in a four-decade interest-rate trend could be just days away.
The U.S. Federal Reserve has generally lowered rates for the past 40 years. There have been increases and decreases along the way, but the overall trend is down...
In other words, Fed policy looks cyclical in the short term, from dovish to hawkish and back again... But over the long term, it has demonstrated a clear dovish bias.
The Fed has indicated it's likely to raise the benchmark fed-funds rate by 75 basis points (0.75 percentage points) at its next meeting next month. ("Fed funds" is the benchmark interest rate the Fed raises and lowers to try to regulate price stability (inflation) and unemployment. When you hear that the Fed cut or raised rates, this is the rate they're adjusting.)
If the Fed goes through with the hike, the fed-funds target range will be 2.25% to 2.5%... right where it was back in July 2019, the last time the Fed reversed course and started cutting rates.
If the Fed continues to raise rates past 2.5%, the odds of a recession – already high enough to be concerning – will ratchet higher.
I'll leave it to the technical analysts to decide if that would constitute a broken trend, but it'd be enough for me if the target rate rises any amount past 2.5%. That would be an early confirmation of our new market reality: higher interest rates, not lower.
Good investing,
Dan Ferris
Editor's note: In order to survive the pain when this asset bubble bursts, it's crucial to not only pick winning investments, but also to avoid the losers...
That's why Dan is hosting an event on October 19 where he'll give away the names of two well-known stocks that you should sell immediately. Being in the right positions could be the difference between surviving this bear market and losing every dollar you've spent your life earning. Get the full details here...