History is Fast Approaching

In the extreme the US share market has the potential to collapse by as much as 90% in value within the next year or two.

Impossible. Chicken little. A broken clock is right twice a day. Doomsayer. Not going to happen. Outlandish rubbish. Ridiculous. You’re dreamin’.

These are the predictable and very understandable (sanitised) responses I’ve received to such a dire prediction.

The fact this prediction has not yet come true, means larger dollops of ridicule are served with each dismissive response.

It would be far easier, safer and conformist for me to write something like: ‘the market will most likely sustain a correction of around 20% in the near future which should provide a buying opportunity for those seeking long term growth.’

This is the standard institutional and mainstream line…a response most consider to be reasonable and easy to comprehend.

And for a large percentage of the share market’s history this standard response is pretty much on the money.

We are naturally inclined towards optimism. Decades of prosperity have conditioned us for growth.

Optimism and growth leave little room in the imagination for overly dire predictions.

However outlying ‘surprises’ do occur — the Titanic did sink, planes do crash, David does beat Goliath, long shots do win.

The rarity of these events is what makes them so difficult to believe in advance.

99 times out of 100 it’s far easier to go with the crowd. The odds are definitely in your favour. Why risk being labelled a ‘looney alarmist’ for making an almost unbelievable and far-fetched prediction?

When it comes to your capital — especially if you have a serious amount of money saved for your retirement — you cannot afford the luxury of dismissing the very real prospect of a Depression-like market collapse. The conditions in play at present (in the market and economy) are only different from the period prior to the Great Depression in one way…they are worse.

Capital destroying, dream shattering and life changing events can and do happen. The lag time between these history making moments makes it easy to forget the lessons, which is why they repeat themselves.

They may only occur once-in-a-lifetime, but if it happens to be at the wrong time in your lifetime then a promised comfortable existence is turned into decades of misery.

We know busts follow booms, contraction follows expansion and the Roaring Twenties were followed by the depressing 30s and 40s.

25-years without a recession has left Australia ill-prepared for a depression-like global economic downturn.

The tantrums over a modest GP co-payment and tightening access to generous entitlements indicates just how out of touch we, as a nation, are with reality. How will we cope when genuine financial hardship reaches our shores?

For those willing to consider the possibility of a ‘once-in-a-lifetime’ market event, there are precedents to consider.

In 1906/07 the US share market suffered a significant decline that became known as ‘The panic of 1907’. The Dow Jones index did not move permanently above its 1906 peak until 1938 (there were times during that 32-year period when the Dow moved above its 1906 high, but the Dow could not hold onto those gains).

In September 1929 the Dow Jones index crashed. The Dow staged a brief recovery in early 1930 only to surrender to the forces of the Great Depression. From its 1929 peak of 381 points the Dow finally collapsed to a low of 41 points in 1932…a loss of 89%. The high of 1929 would not be permanently improved upon until 1954…25 years later.

After its 1932 low, the Dow recovered some lost ground up until August 1937. The market then fell 50% in value over the next few months.

After WWII the western world enjoyed a sustained period of productivity and prosperity. The S&P 500 index reflected the economy’s ‘good times’…reaching a high of 104 points in 1968.

From 1968 to 1982 the S&P stagnated. Over this 14-year period the market gained around 5% in total. There were times during this period when the market tried desperately to move forward, however each time ended in tears. The most spectacular crash was the 1972–74 collapse that saw the market fall nearly 50% in value…wiping out all gains (and more) from the previous four years.

Japan’s share market — Nikkei 225 — peaked in December 1989 at 39000 points — on the back of a debt-laden Japanese ‘miracle’ economy. The Japanese share market finally found its low point in 2009 at 7500 points…a loss of 80% over a 20 year period.

In March 2000 the bell tolled on the ‘dotcom’ period. The S&P 500 index fell in half and the ‘tech-heavy’ NASDAQ index lost 83% of its value.

In 2008/09, the GFC wiped 55% off the value of the S&P index. All gains made from 2003 to 2007 were lost in a matter of months.

The three biggest market collapses in history — 1929, Japan 1990 and the NASDAQ in 2000 — all have similarities — excessive debt and euphoria (a blind refusal to believe the good times could possibly end).

There is no question current US market valuations are a reflection of excessive debt in the system. Euphoria is not quite in the air. But there is a blind belief the Fed has the market’s back and based on this premise you should ‘buy the dips’.

A collapse of 90% is mathematically possible…a fact few people appreciate.

Ben Graham (Buffett’s mentor) said: ‘in the short term, the stock market behaves like a voting machine, but in the long term it acts like a weighing machine.

The market ‘weighs’ earnings with a Price/Earnings (P/E) multiple.

There are two components to the P/E equation. Both are variable…the multiple and the earnings.

An expansion or contraction in one or both of these factors has an influence on Price.

The Shiller PE10 — an inflation adjusted PE average based on a decade of earnings — has tracked the ebb and flow of P/E ratios since 1880.

The lowest recorded Shiller PE 10 ratio was 4.8 times (during the 1920/21 forgotten depression) and the highest 44.2 times (at the peak of the dotcom boom). The ‘deep valleys and high peaks’ in the Shiller PE ratio are a reflection of social mood — despondency to euphoria.

When investors see nothing but heartache they are loathe to pay a high price for future earnings.

Currently the S&P 500 index is trading on a Shiller PE 10 multiple of 26.5. Well above the 135-year average of 16.6.

At present, $1 of earnings is valued at $26.5. What happens if in a deflationary world a $1 of earnings shrinks by 30% to 70 cents and the Shiller P/E falls back to five times? The reduced earnings are valued at $3.50…a fall of 87%.

A contraction in earnings combined with a more pessimistic social mood can and has conspired to drive markets to levels not thought possible during the good times.

Courtesy of the Fed we’ve had a sustained period of ecstasy (with the markets on such a high this comment could be taken literally). The agony is yet to follow.

The previous two downturns (2000/03 and 2008/09) have been in the order of 50%. My guess is the next one will be in the range of a best case 50% and worst case 90% — possibly somewhere in the middle.

The question you need to ask yourself is: can your capital withstand a fall of this magnitude given that any recovery will be a decade or two in the making?


Vern Gowdie,

Editor, Gowdie Family Wealth

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Vern Gowdie has been involved in financial planning since 1986. In 1999, Personal Investor magazine ranked Vern as one of Australia’s Top 50 financial planners. His previous firm, Gowdie Financial Planning was recognized in 2004, 2005, 2006 & 2007, by Independent Financial Adviser (IFA) magazine as one of the top five financial planning firms in Australia. He has been writing his 'Big Picture' column for regional newspapers since 2005 and has been a commentator on financial matters for Prime Radio talkback. His contrarian views often place him at odds with the financial planning profession. Vern is is Founder and Chairman of the Gowdie Family Wealth advisory service, a monthly newsletter with a clear aim: to help you build and protect wealth for future generations of your family. He is also editor of The Gowdie Letter, which aims to help you protect and grow your wealth during the great credit contraction. To have Vern’s enlightening market critique and commentary delivered straight to your inbox, take out a free subscription to Markets and Money here. Official websites and financial eletters Vern writes for:

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