Market participants have been buzzing about a stock market bubble for some time and it appears that bubble has finally started to burst. The S&P plummeted by 5.2 percent, the European STOXX 600 dropped 5 percent, and China’s Hang Seng and the Shanghai index fell 3.8 percent and 4.5 percent respectively for the worst week the market had experienced in two years. 1 2 3 Losses were worse mid-week but a slight rebound on Friday February 16th, 2018 helped limit the damage to some extent. What’s driving this sudden thrashing of equities and what does it mean for precious metals?
Stock Market Bubble
The first reason for the stock market correction is that the market is built to collapse. Equities, in general, are overvalued, as exemplified by their price-earnings (P/E) ratios. Even after last week’s crash, the S&P 500 is currently at 25.52, far above its historical average of 15.69, while the Russell 2000 is at a whopping 149.62. 4 5 In fact, most of the major market indices are at or near historical highs, or even in many cases above levels seen just before the financial crisis in 2008. 6 P/E ratios are a fundamental analysis tool that indicate essentially how much the market is paying for the earnings returned to shareholders. When P/E ratios get much higher than historical averages, investors are paying significantly more for each dollar of income they receive, and thus are likely not pricing the risk involved with that income appropriately.
Rising Interest Rates
The Federal Reserve has been raising rates steadily since December 2015, with only one 0.25 percent increase in both 2015 and 2016, but three in 2017. 7 Three more have been signaled for 2018, and the Fed’s previously dovish stance is now described as hawkish, meaning that they’ve gone from a position of looser monetary policy to tighter monetary policy. 8
The bond markets have taken their cue, and yields have been surging upwards after years of quiet, as inflation expectations, coupled with excessive U.S. government budget deficits, have increased demand on the Treasury bond markets. Last week bond markets spiked on signs that inflation is increasing faster than expected and concerns that Fed rate hikes beyond those that have already been signaled are increasing. 9
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Higher interest rates slow down borrowing 10, which in turn decelerates the growth plans of both companies and consumers. This equates to less income to equity investors, which of course means stock prices fall.
Markets move in cycles. This unavoidable fact means that eventually, a bull market, in equities or anything else, must come to an end at some point. The equities markets have been rising steadily since June 2009, in line with the economic expansion. On a percentage return basis, the current market dwarfs anything seen in history. Nothing lasts forever, and this market is showing its age. 11
Investors Taking Risks
The fact that the market is showing signs of returning to a bullish posture after weeks of carnage is more dangerous than if it leveled off or fell, since the current surge suggests that there are many who think that “buying on the dip” is a strategy that can never lose. 12 The most fearless are even jumping back into shorting volatility, a wildly risky trade with no limit to the losses it can inflict. 13 These are signs of overconfidence, and nothing fuels overconfidence like a quick recovery from a shortfall. If this market bounce continues, expect equities to skyrocket in one last gasp of truly unjustified mania, which will only make the eventual crash worse. The economy is going to slow down and equities will fall.
Flight to Quality
For precious metals, the chaos in equities can mean only one thing: it’s time for a flight to quality. Precious metals are poised for a massive bull run the moment that equities get wiped out, particularly gold. Historically that has been the case and we’re likely to see it happen again. So, get ready for a wild ride in precious metals!