Ray Dalio and his hedge fund research team at Bridgewater Associates have been vocal about their bearish outlook for stocks over the past few months. This year, Bridgewater Associates has predicted equities will see further declines, with Dalio telling investors in June that US stocks would likely fall another 15-20% from current levels by year-end.
Meanwhile, its European equity team recently issued a similar warning regarding the risk of a further market decline in Europe over the coming months.
According to his analysis, inflation will rise 4.5% to 6%, and the Federal Reserve will have to raise interest rates aggressively to curb inflation. In addition, growth will remain weak in the U.S. and Europe while central banks around the world continue their efforts to deleverage the financial system after the financial crisis. These factors should lead to lower valuations and increased volatility for the global stock market in the coming months.
Ray Dalio Predicts a 20 to 25% Drop in the Stock Market
In July, Dalio published a letter on the Bridgewater website that projected further market declines and urged investors to reduce risk in their portfolios. He warned that recent stock gains could be fleeting, and investors should be prepared for further downside volatility as the global economy undergoes a period of heightened uncertainty. He also argued that stock prices were likely to fall sharply over the coming year, making now an ideal time for investors to be opportunistic by selling overvalued positions and raising cash.
“I believe that we are likely in the midst of an extended period of relatively low returns as the world economy attempts to recover from the legacies of the past several decades. The decline in stock prices has been driven in large part by factors such as deflation, deflation fears, excessive valuations, and overleveraging, and I believe that these factors are likely to remain in place for some time.
Stocks tend to fall in two stages
Stage 1: Valuations Drop
The more interest rates rise, the more attractive cash becomes relative to risky assets, which pushes down stock prices.
You’d hold stocks only if you expected them to deliver returns significantly above cash. Valuations would need to drop substantially for stocks to once again become attractive relative to cash.
Stage 2: Earnings Growth Slows
A slowdown in earnings growth is often the next factor that causes stocks to decline as investors come to expect future profits to be lower than in the past.
Slowing or declining earnings are often the result of changing economic conditions. If the economy and earnings drop, you usually also see the stock market decline as well. This can happen for a variety of reasons, including rising interest rates and a slowdown in economic growth.
The effects of higher interest rates takes time to work its way through the system. Stock prices don’t necessarily fall immediately when rates are increased. This is because it takes time for rates to influence the real economy. This is what we call monetary policy transmission. So when will recession hit?
Housing, Orders, Profits and Employment (HOPE)
The HOPE Cycle, created by Piper Sandler’s chief investment strategist Michael Kantrowitz, can offer some insight into when a recession will manifest.
The HOPE Cycle has four stages:
1) Housing Starts to Slow – Housing starts pull back due to high prices, rising mortgage rates, and strict lending standards. Real estate developers and homebuilders are the first to feel the pain because they are particularly sensitive to changes in the housing market. Higher interest rates translate to higher mortage payments and reduce disposable income. Both of which make it harder for people to buy homes. High home prices also push out first-time buyers and make it more difficult for those looking to trade up.
So what does the data tell us?
Construction on new U.S. homes, also known as housing starts, has fallen sharply in recent months. Housing starts in August, however, climbed by seasonally adjusted 12.2% to 1.58 million on the back of a rise in new apartment construction.
2) Orders for Manufactured Goods to Slow – Orders for manufactured goods, also known as factory orders, are a leading indicator of economic activity. Declining orders for manufactured goods indicate that manufacturers are experiencing weaker demand and increased competition. This typically leads to a decline in output and employment.
August data showed that both durable and non-durable goods orders declined for the month. Durable goods orders, which consist of big-ticket items like machinery, autos and appliances, dropped 3.5% during the month. Meanwhile, non-durable goods orders, which includes items such as food, clothing and paper products, fell by 1.6%. These declines came after strong gains in April and May for both durable and nondurable goods orders.
Economists were expecting to see a rebound in durable goods orders, but gains were tempered by weak demand for commercial aircraft and continued weakness in core capital goods orders, which point to an ongoing slowdown in business investment. This suggests that consumer demand remains weak.
3) Profit Growth to Slow – With the economy growing at a solid pace this year, corporate profits have been on the rise. But that growth is now expected to slow.
Corporate profits are expected to rise just 4.9% this year, down from an earlier estimate of 6.1% growth and the slowest pace since the recession ended in 2009.
Now that the economy is in a mature expansion phase, slower growth is projected as companies face rising labor and input costs as well as the challenge of transitioning from cyclically high profit levels to low, more sustainable ones.
4) Employment to Show Weakness – The job market has been one of the strongest economic factors over the past few years. But with wages beginning to flatten out and unemployment levels nearing pre-recession lows, some economists are concerned that the jobs market is losing steam.
Payroll employment increased by about 210,000 jobs in July. ut that was still well below the monthly average of around 215,000 jobs in recent years. In addition, average hourly earnings increased just 0.2% last month, compared to an annual increase of 2.7% in recent months.
So When Will The Recession Hit?
The HOPE Cycle suggests that we are currently in the midst of a slowdown in the orders phase. That’s exactly what we’re seeing with the recent declines in durable goods orders and nondurable goods orders. So will this slowdown continue and cause a recession? The jury is still out on that one. It’s possible that this is just a temporary setback and that we will eventually see the recovery resume.
The next signs would be whether the profits of companies start to slow down. Followed by rising unemployment rates. Then we could expect to see recession indicators such as an inverted yield curve or a decline in consumer confidence begin to emerge.
So Where’s The Opportunity?
First, rather than focusing on what can go wrong in the economy, it’s better to focus on the opportunities that can arise from it.
The bright side about higher interest rates is that you get paid waiting on the sidelines. If stocks do crash in the near future, you’ll be glad you were collecting interest while you waited to invest.
At the same time, consider building your portfolio with defensive stocks and other assets that tend to do well during economic downturns. Timing the market is hard. Using a dollar-cost averaging strategy can help you build a portfolio that gives you exposure to stocks while also minimizing your risk. Finally, it’s important to remember that the current economic conditions are not normal. So rather than trying to time the market, it’s a better idea to focus on investing in high-quality companies and holding for the long term.
In the meantime, if you are looking for case studies, I shared a few ideas here.
Cheers