How Bad Could This Market Crash Get? Very

For the three reasons outlined below, I suspect we’re in the early stages of another major bear market. I hope I’m wrong, but even if I am, it’s worth thinking about how bad things could get.

Anything that happens in the public market will affect the private market, so don’t think that just because you work at a small private company you’ll be immune.  Also, don’t think that stocks will just tank independent of economic weakness (if they do, they’ll just pop back up). If we’re headed into an ugly bear market, it will be because the economy’s fundamentals are breaking down, so you’ll find regular old business tougher, too.

How bad could this bear market get? Sorry to be the bearer of bad news, but the answer is “very.”

According to John Hussman of the Hussman Funds, a dime-a-dozen bear market, which we get about once every 5-10 years, takes stocks down about 30%. For reference, this would put the Dow around 10,000 at the trough. In more severe bear markets, the kind we get every 30 years or so, stocks drop about 50%, which would put the Dow around 7,000 (yes, we just had one of these. Hopefully that will insulate us, but probably not). In the most severe bear market to date, 1929-1932…well, you don’t want to hear about that.

If you find the bear-market logic compelling, should you sell everything now? No. Assuming you’re appropriately diversified (among asset classes, geographies, etc.), you should do absolutely nothing. Market timing is extremely difficult, and the potential costs of blowing it far outweigh the potential gains.

If you’re leveraged to the hilt, however, and can’t stomach the possibility of a 20%+ drop, you should re-balance your portfolio (you should have done this already, but it’s psychologically difficult to do when the market’s going up every day). Once you’re appropriately diversified, you’ll sleep fine regardless of what happens.

Why I Suspect We’re Screwed

*Stocks are still very expensive by valid historical measures (emphasis on “valid”–see below).
*Our economy appears to be headed into the tank.
*It is easy to see how we could “get there from here.”

1. Stocks are still expensive.

By one of the few valid measures of value–cyclically-adjusted P/E–stocks are still very expensive. Specifically, the S&P 500 still trades above 20-times “normalized” earnings–meaning earnings computed using the average profit margin over the past half-century.

(Don’t let your broker persuade you that stocks are now “cheap” because they’re only trading at 15-times earnings. First, that’s not “cheap”–it’s about average. Historically, stocks have spent about half the time below 15 times earnings, sometimes far below, and contrary to another thing your broker will tell you, the level of interest rates is irrelevant. Second, today’s corporate profit margins are still near all-time highs, which means that P/E multiples look artificially low. Unless you believe that, for the first time in history, profit margins are going to remain at all-time highs, you should calculate price-earnings ratios off “cyclically adjusted” earnings.)

2. Our economy appears to be headed into the tank.

Just read the headlines every day. Or this summary.

3. It’s easy to see how we could get there from here.

In recent years, our economy has been driven by “virtuous circle” of rising home prices, increasing net worth, and strong consumer spending. That virtuous circle is now reversing into a vicious cycle of dropping home prices, decreased home-equity withdrawals, and reduced consumer spending. It’s possible we could be getting close to the bottom of that spiral, but I doubt it.

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