Moody’s: ‘Perhaps’ You Should ‘Brace For A 20% Plunge In The Next 18 Months’

So if you, like us, enjoy asking “what could go wrong” in the most sarcastic tone you can possibly muster on a daily (if not hourly) basis, then you will invariably enjoy a recent piece from Moody’s entitled “What Might Trigger The Next Market Plunge?”

Alternatively, if you like brief summaries of market history that are easily digestible by hungry bears, then you’re in for a real treat.

If, on the other hand, you do not like to be reminded that stocks can fall precipitously even when, based on the macro and fundamental backdrop, they probably shouldn’t, you will not enjoy what we’ve excerpted below.

Similarly, if you do not enjoy being reminded about just how bad things can get, then the following brief retrospective probably isn’t for you either.

Finally, if you don’t like to be told by ratings agencies who helped catalyze the last crisis that even if you own a well-diversified portfolio, you should expect to lose at least a fifth of your money “during the next 18 months” then for God’s sake, do not go any further.

Submitted for your (dis)approval…

Via Moody’s

What Might Trigger the Next Market Plunge?

An overvalued equity market and an extraordinarily low VIX index offer no assurance of impending doom for US equities. Provided that interest rates do not rocket higher, expectations of corporate earnings growth should be sufficient for the purpose of avoiding a severe equity market correction that would doubtless include the return of corporate bond yield spreads in excess of 700 bp for high-yield and above 200 bp for Baa-rated issues.

For now, the good news is that early September’s Blue Chip consensus expects core profits, or pretax profits from current production, to grow by 4.4% in 2017 and by 4.5% in 2018. Moreover, earnings-sensitive securities should be able to shoulder the 2.5% 10-year Treasury yield projected for 2017’s final quarter. However, the realization of a projected Q4-2018 average of 3.0% for the 10-year Treasury yield could materially reduce US share prices.

Jarring corrections can occur amid rapid profits growth

Since 1982, there have been seven episodes when the month-long average of the market value of US common stock sank by at least -10% from its then record high. Only two of the seven were not accompanied by at least a -5% drop by core profits’ moving yearlong average from its then record high.

The two exceptions occurred in the 1980s and were largely the consequence of extremely steep and disruptive advances by interest rates. For now, the good news is that core profits are expected to grow through 2018, while an increase by interest rates is not expected to be great enough to send the monthlong average for the market value of US common stock down by -10% or deeper from its current monthlong zenith.

The first deviation saw July 1984’s market value of US common stock sink by -13.3% from its record high of July 1983. Nineteen months would pass before the market value of common equity set a new high in February 1985.

The primary drivers behind 1984’s equity sell-off were twin lift-offs by the federal funds rate from a February 1983 bottom of 8.51% to an August 1984 high of 11.64% and by the 10-year Treasury yield from a May 1983 trough of 10.38% to June 1984’s apex of 13.56%.

Shares prices incurred noteworthy declines in 1984 despite (i) phenomenal real GDP growth of 7.3% (the fastest since 1951’s 8.1%), (ii) a 0.344% average monthly increase by payrolls that equates to 505,000 new jobs per month given the size of today’s workforce, (iv) a relatively low average high-yield bond spread of 311 bp for 1984’s second half, and (v) a nearly 21% yearlong surge by core profits.

The other exception saw the market value of US common stock bottom in December 1987 at -27.4% under its July 1987 top. Not until July 1989 did the market value of common equity set a new record high. From the perspective of most fundamentals, the great stock crash of 1987’s final quarter seemed patently unwarranted. For one thing, as inferred from the high-yield bond spread’s comparatively thin 395 bp average during the quarter prior to October 1987’s stock price collapse, the balance sheets and earnings of US corporations were commendable.

Moreover, core profits were recovering smartly from their -8.5% annual contraction of 1986. After having climbed higher by +17% annually for the combined second and third quarters of 1987, core profits were in the process of posting a +23.5% yearly surge for 1987’s final quarter. Amid the stirring recovery by profits, the annualized quarterly growth of real GDP averaged a stunning 5.0%, while, after adjusting for the greater size of today’s workforce, payrolls expanded by a huge 400,000 jobs per month during the final nine months of 1987.

Interest-rate driven sell-offs ultimately send yields sharply lower

Among the primary culprits behind Q4-1987’s jarring equity market correction were an ascent by the fed funds rate from an October 1986 average of 5.85% to an October 1987 peak of 7.29% and a jump by the 10-year Treasury yield’s month-long average from January 1987’s 7.08% to October 1987’s 9.52%.

It was during October 19, 1987’s stock market crash that the 10-year Treasury yield last posted a reading of at least 10%. Who would have dared to predict back in October 1987 that the 10-year Treasury yield would never again visit 10% at any time during the next 30 years? This brings attention to how interestrate-inspired plunges by the broad equity market are ultimately remedied by substantially lower interest rates.

After peaking at June 1984’s now 35-year high of 13.56%, the 10-year Treasury yield’s month-long average eventually plummeted to April 1986’s 7.30%, by which time the market value of US common stock had soared higher by 59.0% from its low of July 1984. Similarly, after cresting at October 1987’s now 32-year high of 9.52%, the 10-year Treasury yield’s month-long average quickly sank to February 1988’s 8.21%. In response, the month-long average of the market value of common stock rebounded by 8.3% from its low of December 1987. Thus, if higher bond yields precipitate the next major sell-off of equities, chance are that bond yields will reverse course quickly enough.

Equity market plunged by -47%, on average, during last two recessions

The equity market’s five other episodes of at least a -10% drop from the relevant record high followed peaks that were established in May 2015, October 2007, March 2000, June 1998, and June 1990. Two of the deep declines did not occur in the context of a recession, namely the most recent correction of 2015- 2016 and the brief, but severe, setback of 1998’s second half. Compared to their previous highs, the market value of common stock sank by -12.9% before bottoming in February 2016 and fell by -13.7% before bottoming in September 1998. In addition, 15 months passed before the equity market set a new record high in August 2016, while it took only five months for equities to establish a new high in December 1998.

Far more severe was the -50.6% cumulative plunge by the market value of US common stock from an October 2007 high to a March 2009 trough. Not until January 2013 did the market surpass its top of October 2007.

Even longer than the 63-month wait for the market’s full recovery from its post-October 2007 drubbing was the 81-month long hiatus before the market returned to its high of March 2000. After topping off in March 2000, equities would trend lower by a cumulative -42.8% until bottoming in October 2002. But, not until December 2006 did the market set a new high.

Finally, a recession overlapped a -16.6% cumulative slide by the market value of common stock from June 1990’s peak to September 1990’s bottom. Unlike the next two recession-related sell-offs, equities recovered sharply and, by March 1991, the market surpassed its June 1990 high.

In conclusion, the rich valuation of today’s US equity market very much warns of at least a -10% drop in the market value of US common stock in response to either unexpectedly high interest rates or a contraction of profits. Perhaps, the prudent investor should be braced for at least a -20% plunge in the value of a well-diversified portfolio at some point during the next 18 months.

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