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Stocks could plunge 50% in the next year or two: Blodget

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As regular Daily Ticker viewers will know, I have recently become concerned about the possibility of a stock-market crash — or, at the very least, a long period of crappy stock returns.

Importantly, I'm not predicting a crash, but I think the odds of one are increasing. And I am holding onto my own stocks only because I have a balanced portfolio and a long-enough investment horizon that I am comfortable with the possibility of stocks plunging, say, 50%, over the next year or two.

Related: 2013's big winners abandoned 'safety' and bet on central bankers

Of course, stocks have done so well over the past five years that almost everyone is bullish these days, so whenever I talk about the possibility of a market crash, people cackle with laughter or dismiss me as a hater, shortseller, or moron.

For what it's worth, I'm not short stocks. I'm very long. I hope stocks continue to charge higher, but I just can't find much valid data to suggest that they will. I only have vague hopes that the Fed will continue to pump air into the market balloon, the U.S. economy will finally start cranking again, and corporations will continue to find ways to cut more costs and grow their already record-high profit margins and earnings.

Meanwhile:

  • Every valid valuation measure I look at suggests that stocks are at least 40% overvalued
  • Corporate profit margins look like they might finally be rolling over
  • Lots of sentiment indicators are flashing ever-brighter warning signs

None of this means that stocks will crash. But, the valuation data, at least, does suggest that, at best, stocks are likely to produce lousy returns over the next 10 years (0%-2% per year, including dividends).

I'll describe these issues in detail below. Before I do, though, I want to stress that I am not giving you investment advice. I know nothing about your personal investment goals, risk tolerance, or time horizon, and without that information, I have no idea what you should do with your portfolio. (I'm also not allowed to give you investment advice, but that's a different story).

What I do think you should do is ask yourself, "If stocks dropped 50% over the next two years, would I be comfortable with that?" If your answer is "no" — if a drop of that magnitude would cause you to lose sleep or panic and sell — then I would respectfully suggest that you consider rebalancing your portfolio. Not selling all of your stocks — for many reasons, that would almost certainly be dumb. Just rebalancing.

Okay, which valuation measures suggest the stock market is very overvalued?

These, among others:

  • Cyclically adjusted price-earnings ratio (current P/E is 26X vs. 15X average — higher than any time in the past century with the exception of 1999-2000 and, very briefly, in 1929).
  • Market cap to revenue (current ratio of 1.6 vs. 1.0 average).
  • Market cap to GDP (double the pre-1990s norm).

And what about profit margins? Why are they important?

One of the reasons stocks have done so well over the past five years is that U.S. companies have been able to hike their profit margins and profits every year, in part by firing people and replacing them with technology.The trouble with this is two-fold. First, it's not a sustainable way to grow profits: Margins can't go up for ever or eventually they'll be more than revenue. Second, by firing employees, companies are putting the actual spenders in the economy out of work. As a result, too many American consumers are still broke. And consumer spending accounts for about 70% of the economy.

Related: Baby, it’s cold outside: Will the economy get frozen?

So the collective short-term effort of companies to grow earnings by cutting costs is actually making it harder for companies to grow revenue. In any event, profit margins are already at an all-time high, and some analysts think they are rolling over.

Lastly, sentiment...

One of the few folks on Wall Street who shares my concern about the market just sent me a note about various sentiment indicators — measures of the number of analysts who are bullish vs. bearish, etc. By themselves, none of these indicators is particularly meaningful. But it is rare to see so many indicators flashing yellow (extreme bullishness) at the same time.

Do you think Henry is right? Send us a tweet (@DailyTicker) or comment below!

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