Summary
Highlights
In 1929, margin debt was 9% of US GDP. Today, while margin debt alone is 3.5% of GDP, the total leverage, including leveraged ETFs and equity-linked derivatives, amounts to roughly 20% of US GDP, more than double 1929 levels. This significant increase in leverage has occurred during a prolonged period of economic stability since 2009, making the market vulnerable if conditions change.
The S&P 500's earnings are heavily influenced by US consumer spending, particularly from high-income Americans (top 10% contributing 50% of spending). The 'wealth effect' suggests that rising stock markets make people feel wealthier and spend more. With household stock allocation currently at a staggering 40% (up from 5% in 1990), a market downturn and subsequent 'inverse wealth effect' could severely impact earnings. A typical recession sees a 30% earnings drawdown, which could increase to 40% today, potentially dropping the S&P 500 to 4692 points if the PE ratio remains constant.
The current S&P 500 PE ratio of 22.8 is historically elevated, partly due to stable economic growth and increased leverage from instruments like ETFs and options. During a recession, the PE ratio could contract significantly, as seen in past downturns (2001, 2008, 2020). Historically, the average contraction is 30%, but with current leverage, it could be 40%, reducing the PE ratio to around 13.5. A combined 40% decline in earnings and a 40% decline in the PE ratio would result in a 64% drop in the S&P 500 index, bringing it down to approximately 2,818 points, similar to its COVID-19 bottom.
While not a certainty, the risk of such a scenario is present. Investors should prepare in advance to avoid irrational decisions during panic. Three strategies are proposed: 1) Dollar-cost averaging: Consistently invest regardless of market fluctuations. 2) Valuation-based investing: Adjust stock allocation based on market expensiveness, similar to Warren Buffett's approach. 3) Market timing: Actively enter and exit the market based on favorable or unfavorable conditions. The importance of staying unemotional and having a clear strategy is emphasized.