Perhaps for our generation it’s hard to comprehend, but bear markets and crashes are a reality, and historically they have occurred every 7-10 years or so. Some of the world’s greatest investors have been around to predict and/or profit off several crashes and bear markets that have occurred around the world, including George Soros, Jim Rogers, Ray Dalio, Stan Druckenmiller and Warren Buffett.
There are a few driving forces these investors have seen over and over again in helping them predict that a crash or bear market was coming. While obviously it’s easy looking in retrospect, (say the GFC or the Japanese Asset Bubble of the 1980s/1990s) you can use these lessons from some of the world’s greatest investors to help you determine when a crash may manifest and to help protect your portfolio.
Probably the most referred to driver of a crash or bear market that these investors have mentioned is interest rates. In speaking about the 1987 stock market crash George Soros states, “The stock boom [of the 1980s] was fed by a growing supply of dollars, a reduction in liquidity then established the preconditions for a crash.”
Stan Druckenmiller was short the Japanese stock market in 1989 and by 1990 the Nikkei 225 had dropped 30%. He stated, “In late 1989 I became extremely bearish on the Japanese stock market for a variety of reasons…the market appeared in a huge speculative blow-off phase, but most importantly the Bank of Japan had started to dramatically tighten monetary policy.”
Jim Rogers also was short in the US market in 1987. He said, “There were a number of causes [of the 1987 stock market crash], Greenspan, Baker, the fact that money was tight, the steady worsening of the balance of trade…”
There are two explanations as to why the reduction in liquidity may contribute to a crash. Firstly, the value on an asset is the present value of its future discounted cash flows. When interest rates are increased by the central bank, the yield on government debt moves with it, which is used as an anchor for other interest rates in the economy (i.e. corporate debt). Higher costs of capital reduce the present value of future cash flows thus resulting in lower asset prices. Secondly, monetary tightening tends to slow or contract economic activity, as higher debt servicing results in less income available for consumption, which means earnings can’t grow as fast as previously expected by the market.
Historical figures of the federal funds rate and returns of US stocks shows that monetary tightening has generally been accompanied with poor performance in equities. However, there are some exceptions, notably throughout most of the 1960s and 1994-95 and even arguably right now (2015-2017).
The Credit Cycle
Secondly, we turn to the credit cycle. While most of the world was deep in the red during the GFC (2008-2009), Ray Dalio’s Pure Alpha fund was up 10%. Ray Dalio, who runs the world’s largest hedge fund, Bridgewater Associates, bases his investments around a framework he developed called the “economic machine”, which you can find more about in this video: https://www.youtube.com/watch?v=PHe0bXAIuk0.
In short, Dalio says it’s the fluctuations in credit growth in the short term that causes boom and bust scenarios in the economy and in the markets. Regarding him forseeing the GFC, Dalio said, “In 2007 we had rates of debt growth which were unsustainable, that is debt growing faster than income growth. This debt growth was accumulating for the purchase of financial assets, these financial assets were not going to be able to service that debt and that produces a bubble. That’s what caused the 1929 bubble, it happened in Japan in the 1989/1990 bubble it was no different and produced the 2007 bubble.”
Amongst economic and financial analysis, investors have been able to foresee crashes simply be observing that the market is being hysterical, meaning that valuations have become irrationally high into a speculative bubble and must come down. As Warren Buffett’s famous saying goes, “Be fearful when others are greedy, and greedy when others are fearful.”
During the 1920’s in the United States there was a speculative bubble in the stock market. The economy was booming and buying stocks on margin was common, resulting in very high valuations as the S&P 500 cyclical adjusted price-to-earnings ratio got to a peak of 33 in 1929. There’s a famous story of Industrialist John D. Rockefeller in 1928 when he was getting his shoes shined, the shoe shine boy not knowing who he was, started giving Rockefeller stock tips and the next hot buy. Rockefeller decided if a shoe shine boy was giving stock tips, it was time to get out of the market.
Hysteria leads to over confidence which corresponds into the mispricing of risk, excessive valuations and a misallocation of capital and resources, which results in a bust. For example, the overproduction of consumer goods in the USA 1920s, or overconfidence in South East Asian economies in the late 1990’s which lead to the 1997 Asian Financial Crisis, or the mispricing of risk in real estate in America leading up to the GFC.
Another indicator to help guide your analysis is technical breadth. While some of the greatest investors would never use this on its own, it gave them more conviction that markets were overvalued and setting up for a crash.
Technical breadth attempts to gauge the direction of the overall market by analysing the number of companies advancing relative to the number of companies declining. Revisiting the 1987 stock market crash, both Stan Druckenmiller and Jim Rogers used technical breadth to advise their analysis.
Jim Rogers - “You had a market that had spiked up to 2,700 six weeks earlier. If you check, you will see that during 1987, while the S&P and the Dow was going up, the rest of the market was quietly eroding away. In December 1986, I shorted financial stocks and throughout 1987 I didn’t lose any money, even though the Dow and S&P were going through the roof.”
Stan Druckenmiller- “The breadth wasn’t there, that is that market’s strength was primarily concentrated in high capitalisation stocks, with the broad spectrum of issues lagging well behind. This factor made the rally look like a blow-off.”