Why The Stock Market May Fall 50%: Niles

The market's euphoria as stocks nearly doubled in 10 years has turned to pessimism among many investors amid equities' wild swings in 2018. Many investors are warily watching for when a sustained market decline will come - and how steep it will be. Now, well known hedge fund manager Dan Niles, founder of AlphaOne Capital Partners, says stocks could fall by 50%. That forecast is steeper than the 30-40% declines cited by investors in recent months, and would approach the 57% drop seen during the financial crisis a decade ago.

Niles says that while many positive forces are fueling stocks in 2018, "when you get a year from now, they are going to turn out to be really bad," according to CNBC. "That's when the real problems are going to start where you have a 20 to 50 percent type of correction, not the normal 10 to 20 percent type." A correction is a drop in stock prices of more than 10% while a decline of at least 20% represents a bear market.

Niles says the onset of a recession late in 2019 is becoming increasingly likely.

The Last Bear Market

The last bear market ran from October 2007 through March 2009, slicing 57% off the value of the S&P 500 Index (SPX) over the course of 517 calendar days, per Yardeni Research Inc. It took until March 2013, more than four years later, for the index to close once again at the previous peak, per Yahoo Finance.

^SPX data by YCharts

Tailwinds Becoming Headwinds

Niles argues that many of the headwinds of 2018 will turn into powerful tailwinds that drag down the economy and stocks. "Those things that make the economy strong today like low jobless claims, better commodity prices, etc., that's going to start to turn into a headwind," he says. Also, the tailwind causing a roughly 50% gain in oil prices and a boost in energy stocks will turn into a headwind that raises production costs and adds to inflation. While an unemployment rate of 4% is "fantastic" in itself, this is spurring wage hikes that will "crimp profit margins," says Niles.

Niles says the odds of a recession are increasing as the Federal Reserve tightens credit, while the European Central Bank (ECB) is stopping its stimulative policy of quantitative easing (QE). 

Interest Rates Rule

With first quarter earnings reports largely over, interest rates are becoming an increasingly important driver of stock prices. The Wall Street Journal observes: "If rates keep rising, the number of stocks that can generate strong growth will dwindle. That makes for crowded trades that inevitably end in nasty selloffs."

According to data compiled by Thomson Reuters I/B/E/S and cited by the Journal, S&P 500 companies are on track to deliver a more than 26% increase in profits in the first quarter of 2018, the best year-over-year gain since 2010. However, analysts' estimates drop to 6.7% growth for the first quarter of 2019. 

Mounting Pessimism

These factors are helping to fuel a notable increase in pessimism among investors, which risks becoming a self-fulfilling prophecy that undermines the stock market, according to an analysis by Boomberg. Historically high financial asset valuations are a lingering source of worry. Bloomberg cites research showing that the value of financial assets is about 10 times GDP, up sharply from 6 times in the early 1990s. Investors are increasingly worried about the withdrawal of monetary stimulus by central banks. These loose-money policies pumped up asset prices beyond what economic growth would justify.