An Inevitable Crash

A market crash across multiple classes now seems inevitable. With improvements in the economy slowing and in some cases even deteriorating, stock markets and housing prices have continued to climb to new heights. However, even a casual review of facts presents numerous warning signals.

The Reopening Dream

The price of stocks has soared in hopes of not only a strong economy but anticipated raging demand when service, entertainment, dining, and travel industries were able to fully reopen their doors. As I wrote in December of last year, people will be eager to get back to all of the leisure activities they’ve missed out on over the last twelve months, but there’s a limit to how many times a person can really take a vacation or go out to eat. Just because your barbershop was closed most of the year in 2020, it doesn’t mean you’ll get your hair cut five days a week in 2021.

Darden restaurants, one of the largest operators of sit-down dining in the country, recently announced that their same-store sales have surged to nearly the levels they were two years ago and that within a year, they expect to exceed their 2019 revenue. While this is good news, the company’s stock currently trades near an all-time high and significantly higher than its 2019 price. Since Darden’s revenue is still less than it was in 2019, wouldn’t you expect its stock price to be less than it was in 2019, not more?

To justify today’s stock market prices, companies will need to do much more than generating the revenue they did two years ago. Businesses face an uphill battle. Not only have consumers changed their habits, but so have employees. Service businesses that had laid off much of their workforce during the pandemic are now struggling to fill needed positions as they fight to come back. Labor force participation is at a 40 year low as a combination of government policy and changing worker ideals has altered the employment landscape. These employment challenges will result in slower growth and increased costs potentially turning the reopening dream into a nightmare.

Show Me the Money!

Generally, the stock market tries to anticipate the future. So it’s not uncommon for investors to pay a little extra for a stock if they believe the future profits will be there. Sometimes investors get ahead of reality. Since 2019 the S&P 500 Corporate profits have increased about 20.9%. Yet, over that same period, share prices within the S&P 500 index have increased 45.9%. This indicates an almost unreasonable optimism from investors and so far, businesses have not been bringing in the money to justify this optimism.

Again, huge growth will be needed to justify these prices, but the challenges are substantial. For one, where will growth come from? Assuming very little potential for further growth from hospitality and leisure, we could look to consumer spending on goods. Interestingly, one segment of the economy that held up surprisingly well during the pandemic was consumer spending on goods and especially goods that last at least a year or more such as home decor, appliances, cars, etc. Home Depot actually saw a surge in sales during the pandemic as people stuck at home invested in repairs and upgrades. This surge in the sales of long-term goods, which was boosted by stimulus checks, inherently means that demand for these goods will fall substantially over the next one to two years. How many times can you upgrade your washer and dryer or buy a new car in a year? Almost all of the stimulus payments have been spent and due to the timing of those payments, many Americans spent that money on durable goods shipped to their homes leaving little left to bolster the rest of the reopening economy.

One of the largest sectors of the stock market is banking stocks. However, they’re poised to see less income as well. Historically low interest rates mean smaller profits for banking. Additionally, many people have used stimulus funds to reduce credit card debt. Add to this that Wells Fargo recently announced they were shutting down personal lines of credit, another potential income stream. Typically when banks reduce available credit it is a sign that they have concerns about the economy and borrowers’ ability to repay loans. Banking stocks might still show substantial profits due to a massive influx of new speculative investors trying their hand at buying and selling stocks.

Borrowed Time and Money

Speculation is leading the way. When investors start ignoring basic facts and invest anyways, it’s a sure sign of a pending disaster. Gamestop stock increased more than 4000% over the last year. Their business model stayed about the same and their income didn’t see any substantial improvement to justify the price increase. The stock did go viral however as part of an online campaign over Redditt and Twitter to anoint the stock as the next get rich quick scheme. Plenty of new investors jumped in and sent the stock soaring from $20 in December 2020, to nearly $350 per share in January all due to viral speculation with no sound basis backing it up. The stock quickly fell back down to $40 per share and has since been bounced up and down by repeated pump and dump manipulation campaigns. There is a whole generation of traders and speculators who have never invested through a real market crash and it’s a matter of time before many of them grow weary after they experience losses that don’t bounce back in a matter of days or weeks for the first time.

Gamestop is only one example of the type of speculation going on in the market. Speculation is being amplified by easy access to margin debt, which allows investors to buy stock with money they don’t even have. The total amount of margin debt currently outstanding is a staggering $861 billion. While this is an all-time high, the rate that total margin debt has increased in the last year tells more of the story. Preceding the Dot-Com crash in 2000 was an 80% increase in margin debt, with a 60% increase preceding the Great Recession in 2008. Both of those crashes resulted in 50% reductions in margin debt. In 2021, we’ve seen a 70% increase in margin debt, but the crash hasn’t happened yet.

The Real Estate Anchor

While many investors would argue that real estate prices and stocks have little to do with each other, I’d say that nothing could be further from the truth. Gains in stocks and real estate both boost real wealth and consumer confidence. When one suffers, so does the other as investors are forced to liquidate whatever investments they have to make up for losses, or at the very least, cut spending and work to preserve capital.

Since last year, real estate prices have soared to unbelievable levels as many potential sellers held on to their properties until they were a little more certain about the future of the economy and their lives in general. But skyrocketing prices are now going to bring many more sellers into the market hoping to cash in their gains. The percentage of Americans who believe now is a good time to sell a home has surged to 77% up from around 65% through 2018 and 2019. Pair that with the moratorium on foreclosures ending at the end of the month and we can clearly see that the number of houses available for sale is going to jump in the next several months. While the percentage of people who believe now is the time to sell is at an all-time high, the converse is true for the percentage of people who think now is a bad time to buy at 64% (over the past decade typically about 30% of respondents thought it was a bad time to buy in any given year). The confluence of more people being ready to sell and fewer people willing to buy is a drop in real estate prices.

Typically when a market begins to come down, new buyers tend to want to wait to see if prices fall further. This could limit the number of new buyers and increase the number of sellers hoping to sell before their property loses much more value. Falling real estate prices impact the stock market in two ways. One, banks, real estate investment companies, and construction companies are all impacted directly bringing the value of their stocks down. Secondly, when people see the value of their home falling, whether they intend to sell or not, they feel like they’ve lost that money and are more likely to pull money out of the stock market to prevent additional losses. A falling stock market could then lead to broader economy fears scaring away even more home buyers.

I’m Not Alone

“When you have reached this level of obvious super-enthusiasm, the bubble has always, without exception, broken in the next few months, not a few years…We will have to live, potentially, possibly, with the biggest loss of perceived value from assets that we have ever seen.” –Jeremy Grantham

“It is simple. Greatest Speculative Bubble of All Time in All Things. By two orders of magnitude.” -Michael Burry

“Everything I look at would suggest caution, intermediate to long term, would be the rule of the day……When this market has a reason to go down, it’s going to go down so fast your head’s going to spin.” – Leon Cooperman

“I have no doubt that we are in a raging mania in all assets…I will be surprised if we’re not out of the stock market by the end of the year, just because the bubbles can’t last that long.” -Stanley Druckenmiller

“The generation that is trading right now has never gone through a sustained correction. It’s coming — I don’t know when, I don’t know what’ll trigger it, but they will learn their lesson.” -Kevin O’Leary

I don’t believe this will be one of the biggest crashes in history, but there will be a substantial correction before long. We’re just waiting to find out what pinprick lets the air out.