'Daredevil' Stock Market Poised to Drop 40%: Stockman

The mix of tax cuts and increased federal spending passed by Congress and signed into law by President Trump in recent months may be giving the economy and corporate profits a big boost right now, but the downside is that the federal budget deficit is projected to reach a staggering $1 trillion in 2019, according to analysis by the Congressional Budget Office (CBO), as cited by PBS. This worries David Stockman, who came to national prominence as director of the Office of Management and Budget (OMB) under President Ronald Reagan in 1981. "I call this a daredevil market. It's all risk and very little reward in the path ahead," he said in a TV interview with CNBC, adding, "This market is just way, way over-priced for reality."

'Crazily Priced'

"The S&P 500 could easily drop to 1,600 because earnings could drop to $75 a share the next time we have a recession," Stockman opined. This would represent a plunge of roughly 42% from current prices, sending the index back to where it was on May 3, 2013. He also noted, with alarm: "We're about eight or nine years into this expansion. Everything is crazily priced. I mean the S&P 500 at 24 times at the end, tippy top of a business cycle." 

^SPX data by YCharts

Holding Firm

A year ago, Stockman also predicted that the S&P 500 Index (SPX) was due for a pullback to 1,600. Based on the value of the index back then, that would have represented a decline of more than 30%. Instead, the S&P 500 has risen by about 14% over the past year.

When pressed to predict when stocks might begin the bear market plunge that he foresees, Stockman declined to offer a timetable: "When the catalyst finally comes, it's hard to say. No one can ever define what the black swan is because that is why it's called a black swan." During the last bear market, from October 2007 to March 2009, the S&P 500 shed 57% of its value, per Yardeni Research Inc.

'It's Just Irresponsible Crazy'

Stockman was scathing in his assessment of the economic program championed by Trump and enacted by Congress: "These tax cuts are going to add to the deficit in the 10th year of an expansion. It's just irresponsible crazy. It's all going to stock buybacks and M&A deals anyway. That doesn't cause the economy to grow. It's just a short-term boost to the stock market that doesn't last."

Additionally, Stockman is alarmed by the potential impact of a ballooning federal deficit on interest rates. As yields are propelled upward, the carrying costs on the national debt will increase, resulting in yet higher deficits.

Rising Rates and Stocks

Higher interest rates also will increase borrowing costs for companies, decreasing profits. A notable exception tends to be banks, which normally increase their net interest spreads, and thus their profit margins, as interest rates rise. Finally, stock valuations generally have an inverse relationship with interest rates, as rising rates cause anticipated future profits and dividends to have a lower present value. Meanwhile, rising rates mean that bonds become relatively more attractive investments compared to stocks.

Other Big Bearish Calls

In recent months, Investopedia has reported on other prominent market participants who are calling for big market declines in the near future. Among them are:

• Hedge fund manager Dan Niles warns of a 50% plunge in the S&P 500. (For more, see also: Why The Stock Market May Fall 50%: Niles.)
• Emerging markets fund manager Mark Mobius foresees a 30% drop. (For more, see also: Contrarian Mark Mobius Sees a 30% Stock Plunge.)
• Scott Minerd, chief investment officer (CIO) at Guggenheim Partners, warned of a 40% decline. (For more, see also: Stocks On 'Collision Course With Disaster,' Face 40% Drop.)
• Daniel Pinto, co-chief operating officer (COO) of JPMorgan Chase & Co. (JPM), stated that a pullback of 20% to 40% was likely within the next two or three years. (For more, see also: Stock Investors Should Brace for 40% Plunge: JPMorgan.)

In addition to the matter of high valuations cited by Stockman other factors contributing to pessimism about future stock price gains include, among others, Trump's protectionist moves and rhetoric, soaring margin debt, and crowded investments in tech stocks.