Why the next stock market crash will be faster and bigger than ever before

by Simon Black, Sovereign Man:

US stock markets hit another all-time high on Friday.

The S&P 500 is nearing 2,600 and the Dow is over 23,300.

In fact, US stocks have only been more expensive two times since 1881.

According to Yale economist Robert Shiller’s Cyclically Adjusted Price to Earnings (CAPE) ratio – which is the market price divided by ten years’ average earnings – the S&P 500 is above 31. The last two times the market reached such a high valuation were just before the Great Depression in 1929 and the tech bubble in 1999-2000.

Some of the blame for high valuation goes to the so-called “FANG” stocks (Facebook, Amazon, Netflix and Google), whose average P/E is now around 130.

But there’s something different about today’s bull market…

Simply put, everything is going up at once.

Leading up to the tech bubble bursting, investors would dump defensive stocks (thereby pushing down their valuations) to buy high-flying tech stocks like Intel and Cisco – the result was a valuation dispersion.

The S&P cap-weighted index (which was influenced by the high valuations of the S&P’s most expensive tech stocks) traded at 30.6 times earnings. The equal-weighted S&P index (which, as the name implies, weights each constituent stock equally, regardless of size) traded at 20.7 times.

Today, despite sky-high FANG valuations, the S&P market-cap weighted and equal-weighted indexes both trade at around 22 times earnings.

Thanks to the trillions of dollars printed by the Federal Reserve (and the popularity of passive investing, which we’ll discuss in a moment), investors are buying everything.

In a recent report, investment bank Morgan Stanley wrote:

We say this not as hyperbole, but based on a quantitative perspective… Dispersions in valuations and growth rates are among the lowest in the last 40 years; stocks are at their most idiosyncratic since 2001.

So, ask yourself… With stocks trading at some of the highest levels in history, is now the time to be adding more equity risk?

Or, as billionaire hedge fund manager Seth Klarman notes… “When securities prices are high, as they are today, the perception of risk is muted, but the risks to investors are quite elevated.”

Volatility – as measured by the Volatility Index (VIX) – remains below 10 (close to its lowest levels in history). For comparison, the VIX hit 89.53 in October 2008, as the market plunged.

We haven’t seen a 3% down day since the election. And if that holds through the end of the year, it will be the longest streak in history.

And this false sense of security comes just as the main driver of this bull market – the trillions of dollars global central banks printed after the GFC – is coming to an end.

Markets saw around $500 billion of accommodation in 2016. And “quantitative tightening” should suck about $1 trillion out of the markets in 2018… That’s a $1.5 trillion swing in two years. And it’s a major headwind for today’s already overvalued markets.

But that’s just one issue. Remember, we also have…

Slowing global growth, record-high debt, potential nuclear war with North Korea, a rising world power in China, and cyber terrorism (just to name a few of the potential pitfalls) …

Still, investors continue to put money to work without a care in the world.

And more and more of that money is being invested with ZERO consideration of market valuation – thanks to the rise of passive investing.

Through July 2017, exchange-traded funds (ETFs) took in a record $391 billion – surpassing 2016’s record inflow of $390 billion.

According to Bank of America, 37% of the S&P 500 stocks are now managed passively.

Investors in these passive index funds and ETFs pay super-low fees in return for an automated investment process. For example, any money invested in a passively-managed S&P 500 ETF is equally distributed (based on market cap weighting) across the 500 S&P companies… So, companies like Apple, Google, Facebook and Amazon get the biggest share of that money.

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