We’re witnessing a very typical pattern right before recessions and market collapses.
The market’s price-to-earnings (P/E) ratio is currently at a level seen only before recessions.
Before we flat out say there will be a recession, we need to dig deeper into why we’re here today.
First, we can look at earnings (the E in P/E.) Earnings have stalled. Yet prices (the P in P/E) have still rallied. This pushes the P/E ratio upward.
This metric is a simple way of saying that something has to break. Usually, it means that prices must fall back to earth. However, this cycle is different.
Today, we’re in a zero-interest rate (ZIRP) environment.
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This is forcing money to flood the stock markets for two reasons. First, because market yields are sexier than 1% in CDs. And second, because companies can borrow billions of dollars in debt at lowest interest rates. This allows them to buy back their own shares.
(Note: Executives are mostly compensated in shares. They’ll do whatever they can to boost share prices.)
Corporate buybacks are boosting shares in a couple ways. First, it can create the illusion of earnings-per-share (EPS) growth. When earnings aren’t growing, share buybacks reduce the number of shares. With a lower number of outstanding shares, earnings magically seem better on a per-share basis.
Second, because companies can borrow billions of dollars in debt at super low-interest rates, this allows them to buy back their own shares with minimal capital risk. It’s a cheap way to boost the stock price. And the market has loved it.
Take a look at the buyback chart again above.
Notice the stock market started getting shaky precisely when buybacks themselves stopped rising.
This wasn’t a coincidence.
But now, the central banks are propping up the market as earnings drift lower and buybacks stall.
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Japan’s central bank formally announced it was buying foreign equities earlier this year. And the Bank of Switzerland was just revealed to have added tens of billions of US equities to its portfolio.
The central banks are replacing corporate buyers.
Consider one more dimension…
Smart money knows a recession is coming… but it nevertheless is buying equities that are obviously overpriced. Why? Because they know interest rates are heading even lower.
Sure, the Fed talks a good game about raising rates. But they aren’t serious.
Lower interest rates are what happens when the economy slows. Since we’re already at zero, we’re likely headed to negative interest rates. There is already more than $13 trillion in negative yielding government debt. The US is next. And the smart money knows it.
Stock markets look more attractive the lower interest rates fall.
Personally, I’ve already exited the market based on current fundamentals. Maybe I was early… especially if the Federal Reserve (Fed) plays their games as the economy continues to slow.
But it’s not wise to fight the tide.
The Fed can bail out the sinking economic ship all it wants. But it’s still sinking.
I may have missed the run-up in the market as stocks broke out to all-time highs (Oh well). I might have missed more gains. But when the market turns and drops 15%, I’ll have remained safe and dry.
