I know what you’re thinking. The economy is booming right now! Unemployment is at its lowest level in decades, the stock market is setting record highs, consumer optimism is through the roof. On what grounds could you possibly be predicting a recession?

Well, you’re right on one account. This is pure speculation. But, if these predictions do come true, remember that you heard it here first.

The basis for my pessimism is the fact that the economy is booming right now. Unemployment is below sustainable levels, stocks are grossly overvalued, and consumer debt and default levels are entering into the scary zone.

 

The Business Cycle

 

People give too much credit for the economy to the person sitting in the oval office. The reality is, the market moves based on the aggregate of individual behaviors, not based on the behavior of one individual. Yes, the markets must adjust to policy changes. That is true. But as policies, productivity, and innovation push the actors in the system, the system adapts, adjusts, and pushes back. You see, the economy is always changing and the government is only one player in a larger game.

These changes do lead to tectonic shifts in the economy, but not necessarily when the are introduced. New policies and new technologies put pressure on the status quo, until eventually it shakes our world. Once things settle down, we rebuild, incorporating those new pressures into our new status quo. This is a process that has been repeating itself for centuries, and we are due for another shakeup “any day now.”

 

Animal Spirits

 

The famous economist John Maynard Keynes once famously said that people are driven by “a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities.” He coined this phenomenon “Animal Spirits” which drives consumer behavior. In other words, real people don’t make choices the way mathematical models might predict. They are driven by something more primal. Our instincts lead us into avoidable situations.

In the case of the economy, the “Animal Spirit” that is the culprit is called “herd mentality.” Basically it comes down to this. When you fear the market is going to fall, you sideline your investments. That is a rational thing to do. But, if you then notice that all of your friends are making big money while you are making none, it drives you to want to join them. Against your own logic, analysis, and beliefs, you join the herd so that you are not left behind. In other words, your greed overrides your fear. It turns out that this battle between greed and fear is exactly what drives the business cycle. It pushes the market past its sustainable level, even when all the signs are clearly visible that those levels cannot be maintained and must correct. It is not until the markets are so overvalued that it is obvious to everyone that this cannot go on forever. At some point, people start wanting to cash in their winnings and go home, but they can’t find a “greater fool” anymore. Then people start to worry, they get determined to sell and cut their prices. Fear takes over and not enough greed remains. As others in the herd see the tide turning, they change course as well. Suddenly, the entire market is in a race to the bottom until some savvy players realize that there is a great “buying opportunity” to take advantage of.

 

Prediction

 

The current price of the Dow Jones is right around $22,000 today. That equates to an unwarranted valuation of 26 times earnings, which cannot possibly continue. Either the market must level while earnings catch up to value, or the value must decline to a more realistic valuation of present earnings. There is far too much hype right now about the possibility of tax reform, infrastructure projects, and financial regulation changes. This hype has already been priced into the values, and probably by too much. Therefore, what I expect to see is one of two things. Either these reform efforts fail and the markets will adjust back to correct levels, or these efforts will pass and the federal reserve will undermine those expansionary pressures with contractionary monetary policy. In either case, the value that has been priced into the market does not actually exist. There in little room for me to believe that the market will continue on its current path.

However, I should warn you before you sideline your retirement accounts. Timing the market is fickle. Even when are the signs are glaringly obvious, the momentum of the herd can continue to push in an unsustainable direction. It may take months or even years for the market to adjust, in the meantime you may miss out on that continued unsustainable growth.

For example, in 2003 I was selling real estate. I could tell something was wrong in the market. I remember selling a second home to a pizza delivery driver with no savings and thinking, “this can’t go on.” I quit that job predicting a market crash and sold my house in 2004. It took about 4 years for the market to act on what was glaringly obvious. But when it did act, it happened fast. Within a year, the value of homes was cut in half.

I believe the tide is starting to turn in the stock market. I think that reform efforts will fail in congress and the market will drop back to around $16,000 (a 27% fall from current value). I expect this process to start in Q4 of this year, but to be dragged out over several months as holiday spending reports should be strong and will prop up value for a while. By February 2018, I believe the market will correct to its true value. Then, as the last bastion of the current administration crumbles on top of failed policy attempts, we will see political ramifications. It would not surprise me to see an impeachment or resignation shortly after the midterm elections.

If the reform efforts do pass, I predict something worse. The markets will rise as people continue to be optimistic about the economic growth, not realizing that those gains are already priced in. The market will continue up to around $25,000 before eventually falling when reality sets in, likely not until 2019 or early 2020. When it falls, it will over correct, dropping to around $12,000 (a 52% fall) over the course of just 2 months, before starting its climb back up. In this case, economic turmoil will be the story that drives the 2020 election with geopolitical instability as the wildcard.

Time will tell if my crystal ball is working. In reality, I hope I am wrong. But I’m well diversified right now, just in case.

-Ed King, Principle Economist

 

 

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