Over the past few years there’ve been many broad and very public predictions of an impending market downturn. I remember starting to hear them back in 2017 when people were guessing a recession might happen within 6–12 months. Obviously, that never happened. It still hasn’t, but predictions have only grown stronger in conviction.
Why? Because markets keep hitting high after high without the supporting operating fundamentals. Logically, there has to be a top; a point where markets pull back.
What’s happening now
Now into 2020, we’ve had a bull run for more than a decade. The S&P 500 is at a record high. The Nasdaq Composite has also hit a record high. In January, the Dow Jones Industrial Average hit a record high.
So, what is today’s indicator that markets will head south?
Markets today are inflated by sentiment. While stock markets fluctuate on macro fundamentals like global and national economic conditions, they are also moved by sentiment. Sentiment isn’t something that can be quantified; it’s a feeling that investors share based on ideas and rumors which can lead to excitement, fear, and/or chaos. Because markets have been strong for so long, because there is significant political rhetoric aimed at increasing investor confidence, and because companies have been buying positive sentiment, investors have maintained a strong long position on the future — they’ve remained hopeful.
Too much hot air, too much bubble
The answer is the “credit bubble.” Investors, consumers, corporations, and governments are holding a heck of a lot of debt. When you take on debt, you are making a commitment that future you can pay it back. Paying back debt usually means spending less. Today, the economy is being propped up by debt and there is fear brewing that some of the debt may not be able to be repaid. When interest rates are low for such a long time (they’ve been very low since the last recession), people get used to easy borrowing. The focus turns to borrowing instead of productivity (making money), means cash reserves are low and debt loads are high. Borrowers take on more credit to service existing debts. When interest rates increase or credit is cut off, there will likely be an issue repaying the debt.
For clarity, a recession is different from a market correction. Stock markets have regular corrections. Also called pullbacks and drawdowns, corrections are normal and expected. They respond to company news, trading volume, and world events. In contrast, a recession is what happens when an economy contracts, or shrinks, and everything pulls back. In the case of a recession, markets experience an extended down period (at least two consecutive quarters of declining performance across an entire economy). Short term recessions also happen with some regularity, so the term should be used with nuance. For context, the 2008–09 recession is often referred to as a “crisis,” because of how long lasting and detrimental it was.
And the credit goes to…
I understand the greatest concern today to be corporate America not being able to service its debt. Many corporations over-leveraged themselves by using cheap debt to finance stock buybacks in order to keep investors and board members happy. With stock buybacks, their mission was to drive up their stock price when operating results were poor. It’s literally throwing good money after bad, trying to change the result but only providing a quick band aid fix. Now there is concern that these massive corporations won’t have a way to pay the debt back.
But bad corporate results are being rescued by the buoy of hope, an artificial and short-lived life ring. We’ve seen stocks continue to trend up while the underlying companies haven’t increased their own fundamentals, like sustainable growth rate or revenue.
But not to be forgotten…
Consumers have also created their own debt bubble. Credit card debt is ever growing and becoming increasingly hard to pay off. But unlike corporate debt, consumer debt isn’t cheap. It’s crazy expensive. So the pain is far worse for the consumer who all of a sudden can’t manage debt repayment with a staggering interest rate that is compounding their level of debt. What might prevent someone from making their credit card payments? Losing their job. What might be the catalyst for job loss? Corporations who can’t pay back their debt.
This time around, I don’t think we’re going to see a recession anything like what happened in 2008. This is mostly because market activities leading up to 2008 went largely unregulated. After the 2008–09 crisis, regulation was put in place to avoid another such calamity. But regulation can only do so much, and in a capitalist environment, making money is the driving force. This means that a bubble will grow and at some point it will burst — it’s the capitalist cycle of bull and bear markets. Today’s credit bubble is smaller and a little softer than that of 2008–09’s housing bubble, but it will hurt. And while there’s no way of knowing exactly what will happen or when it will happen, it pays to understand what we’re dealing with.
Want to learn more about economic cycles and how it all works? This video is great at explaining how the economy works at a high level.
