via Nick Giambruno:
I think there’s a very high chance of a stock market crash of historic proportions before the end of Trump’s first term.
That’s because the Federal Reserve’s current rate-hiking cycle, which started in 2015, is set to pop “the everything bubble.”
I’ll explain how this could all play out in a moment. But first, you need to know how the Fed creates the boom-bust cycle…
To start, the Fed encourages malinvestment by suppressing interest rates lower than their natural levels. This leads companies to invest in plants, equipment, and other capital assets that only appear profitable because borrowing money is cheap.
This, in turn, leads to misallocated capital – and eventually, economic loss when interest rates rise, making previously economic investments uneconomic.
Think of this dynamic like a variable rate mortgage. Artificially low interest rates encourage individual home buyers to take out mortgages. If interest rates stay low, they can make the payments and maintain the illusion of solvency.
But once interest rates rise, the mortgage interest payments adjust higher, making them less and less affordable until, eventually, the borrower defaults.
In short, bubbles are inflated when easy money from low interest rates floods into a certain asset.
Rate hikes do the opposite. They suck money out of the economy and pop the bubbles created from low rates.
It Almost Always Ends in a Crisis
Almost every Fed rate-hiking cycle ends in a crisis. Sometimes it starts abroad, but it always filters back to U.S. markets.
Specifically, 16 of the last 19 times the Fed started a series of interest rate hikes, some sort of crisis that tanked the stock market followed. That’s around 84% of the time.
You can see some of the more prominent examples in the chart below.
Let’s walk through a few of the major crises…
• 1929 Wall Street Crash
Throughout the 1920s, the Federal Reserve’s easy money policies helped create an enormous stock market bubble.
In August 1929, the Fed raised interest rates and effectively ended the easy credit.
Only a few months later, the bubble burst on Black Tuesday. The Dow lost over 12% that day. It was the most devastating stock market crash in the U.S. up to that point. It also signaled the beginning of the Great Depression.
Between 1929 and 1932, the stock market went on to lose 86% of its value.
• 1987 Stock Market Crash
In February 1987, the Fed decided to tighten by withdrawing liquidity from the market. This pushed interest rates up.
They continued to tighten until the “Black Monday” crash in October of that year, when the S&P 500 lost 33% of its value.
At that point, the Fed quickly reversed its course and started easing again. It was the Chairman of the Federal Reserve Alan Greenspan’s first – but not last – bungled attempt to raise interest rates.
• Asia Crisis and LTCM Collapse
A similar pattern played out in the mid-1990s. Emerging markets – which had borrowed from foreigners during a period of relatively low interest rates – found themselves in big trouble once Greenspan’s Fed started to raise rates.
This time, the crisis started in Asia, spread to Russia, and then finally hit the U.S., where markets fell over 20%.
Long-Term Capital Management (LTCM) was a large U.S. hedge fund. It had borrowed heavily to invest in Russia and the affected Asian countries. It soon found itself insolvent. For the Fed, however, its size meant the fund was “too big to fail.” Eventually, LTCM was bailed out.
• Tech Bubble
Greenspan’s next rate-hike cycle helped to puncture the tech bubble (which he’d helped inflate with easy money). After the tech bubble burst, the S&P 500 was cut in half.
• Subprime Meltdown and the 2008 Financial Crisis
The end of the tech bubble caused an economic downturn. Alan Greenspan’s Fed responded by dramatically lowering interest rates. This new, easy money ended up flowing into the housing market.
Then in 2004, the Fed embarked on another rate-hiking cycle. The higher interest rates made it impossible for many Americans to service their mortgage debts. Mortgage debts were widely securitized and sold to large financial institutions.
When the underlying mortgages started to go south, so did these mortgage-backed securities, and so did the financial institutions that held them.
It created a cascading crisis that nearly collapsed the global financial system. The S&P 500 fell by over 56%.
• 2018: The “Everything Bubble”
I think another crisis is imminent…
As you probably know, the Fed responded to the 2008 financial crisis with unprecedented amounts of easy money.
Think of the trillions of dollars in money printing programs – euphemistically called quantitative easing (QE) 1, 2, and 3.
At the same time, the Fed effectively took interest rates to zero, the lowest they’ve been in the entire history of the U.S.
Allegedly, the Fed did this all to save the economy. In reality, it has created enormous and unprecedented economic distortions and misallocations of capital. And it’s all going to be flushed out.
In other words, the Fed’s response to the last crisis sowed the seeds for an even bigger crisis.
The trillions of dollars the Fed “printed” created not just a housing bubble or a tech bubble, but an “everything bubble.”
The Fed took interest rates to zero in 2008. It held them there until December 2015 – nearly seven years.
For perspective, the Fed inflated the housing bubble with about two years of 1% interest rates. So it’s hard to fathom how much it distorted the economy with seven years of 0% interest rates.
The Fed Will Pop This Bubble, Too
Since December 2015, the Fed has been steadily raising rates, roughly 0.25% per quarter.
I think this rate-hike cycle is going to pop the “everything bubble.” And I see multiple warning signs that this pop is imminent.
• Warning Sign No. 1 – Emerging Markets Are Flashing Red
Earlier this year, the Turkish lira lost over 40% of its value. The Argentine peso tanked a similar amount.
These currency crises could foreshadow a coming crisis in the U.S., much in the same way the Asian financial crisis/Russian debt default did in the late 1990s.
• Warning Sign No. 2 – Unsustainable Economic Expansion
Trillions of dollars in easy money have fueled the second-longest economic expansion in U.S. history, as measured by GDP. If it’s sustained until July 2019, it will become the longest in U.S. history.
In other words, by historical standards, the current economic expansion will likely end before the next presidential election.
• Warning Sign No. 3 – The Longest Bull Market Yet
Earlier this year, the U.S. stock market broke the all-time record for the longest bull market in history. The market has been rising for nearly a decade straight without a 20% correction.
Meanwhile, stock market valuations are nearing their highest levels in all of history.
The S&P 500’s CAPE ratio, for example, is now the second-highest it’s ever been. (A high CAPE ratio means stocks are expensive.) The only time it was higher was right before the tech bubble burst.
Every time stock valuations have approached these nosebleed levels, a major crash has followed.
Preparing for the Pop
The U.S. economy and stock market are overdue for a recession and correction by any historical standard, regardless of what the Fed does.
But when you add in the Fed’s current rate-hiking cycle – the same catalyst for previous bubble pops – the likelihood of a stock market crash of historic proportions, before the end of Trump’s first term, is very high.
That’s why investors should prepare now. One way to do that is by shorting the market. That means betting the market will fall.
Keep in mind, I’m not in the habit of making “doomsday” predictions. Simply put, the Fed has warped the economy far more drastically than it did in the 1920s, during the tech or housing bubbles, or during any other period in history.
I expect the resulting stock market crash to be that much bigger.