Just yesterday, in a question and answer session on Reddit, multi-billionaire businessman and philanthropist, Bill Gates said that a financial crisis of the magnitude of 2018 is “a certainty”. He also mentioned that legendary investor, Warren Buffet is convinced of it as well. The question is why? Why do so many investors believe a stock market crash is coming?
Most astute investors know that stock valuations are at or near historical highs, but that is not enough to justify a historical financial crash. Why won’t we have a simple market correction? Here’s a possible explanation to why Mr. Gates is so “certain”. In a published study done by Michael Lebowitz, the author shows that even astute investors may be unaware that today’s valuations (once they’ve been adjusted for the level of economic growth and heightened profit margins) aren’t like anything we’ve dealt with recently — in fact, they defy comparison with any period after the Great Depression. It can be easily claimed that when buying stocks, each dollar spent buys potential growth. When the purchase of stocks is based on a premise of growth that cannot be fulfilled, the investor is putting himself in harms’ way.
In a previous article (part 1 of this series), we showed the conclusive evidence that our national GDP growth is declining, so from a national perspective, investments done today are buying a declining national GDP or less growth. This is one weak leg on which current investment stands. The additional leg of the argument that stock prices are inflated beyond what investors foresee, is corporate profit margins.
Corporate Margins are Cyclical
Corporate profit margins, or the difference between sales and net profits, are considered one of the most cyclical fundamental measures that exist. The reason is that, when margins are high in certain industries, new entrants are lured to those industries by the higher margins. Conversely, when margins are low, companies exit those industries and those remaining companies can increase margins. The graph below shows the cyclical nature of corporate margins since 1948.
When margins are higher or lower than average, it makes sense to assume they will revert to the average over time, which means they will go lower. Therefore, the author proposes adjusting the traditional price per earning of the stocks to the cyclical patterns of lower GDP and the potentially peak profit margins. The logic for normalizing Cyclical Adjusted Price per Earning (“CAPE”) based on current margins and its historical tendency, provides a valuation level, as shown below, that is comparable to other periods.
If you accept this methodology, the conclusion from the data available shows that investors are paying over three times the average and almost twice as much as the prior peak for a dollar of economic growth. Furthermore, it is happening at a time when we are clearly late in the economic cycle and the outlook for growth, even if one is optimistic, is well below that required to justify such a level. If this study is correct, then a stock market crash is coming. Not only that, but the oncoming financial crash will be a “perfect storm”: a historic downturn which will be historic, rivaling the 80% stock price declines of the Great Depression. Is that what’s driving Bill Gates’ conviction?
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