Beware the Stock Market Forecast for the Next 3 Months (Q3 2017) – Lombardi Letter

The Stock Market Forecast for the Next Three Months (Q3 2017)

Various signals point to a dangerous overheating of financial markets and a poor memory of what they experienced in 2008. Therefore, investors should beware the stock market forecast for the next three months (Q3 2017). This is especially true for the U.S. markets. The stock market outlook is cautious at best, but the third quarter of 2017 looks particularly vulnerable to shocks.

Before any analysis or general stock market prediction begins, it’s important to establish a factor that many have overlooked about the stock market forecast for 2017.  The financial leverage levels of U.S. companies have risen significantly since 2008. Meanwhile, the market capitalization levels of such companies compared to earnings (P/E) are downright ridiculous.

Even Europe, which many had given up as a basket case, seems to be better than Wall Street. Instead, in the United States, many are calling out the markets for jumping headfirst into another 2008 subprime crisis. That’s why investors should not be worried whether or not the markets are heading into turbulence. In fact, there are experts predicting a stock market crash.

When Is the Next Crash Going to Happen?

The timing is all about getting the right trigger. The black swan event that provokes a domino effect is unknown. That’s the nature of black swans; you can’t predict them. Black swans work like the best-written effects in a well-crafted horror movie. Audiences (or investors, in the market’s case) cannot see the dangers that lurk behind seemingly secure looking situations. But investors can definitely identify the dangers to the U.S. economic outlook. They understand the risks that triggered them after the fact.

One thing is certain. Market performance does not follow a fixed pattern that can be predicted with pinpoint accuracy. Nobody knows when the next market crash is going to happen. But wise investors—that is, those who pay attention to various factors and to market history—are likely seeing that the current bull market makes little sense. Just look at the collapse of U.S. retail to get an idea.

stock marker forecast for next three months

Wall Street is not just experiencing a case of “irrational exuberance.” It’s experiencing, irrational expectation. In 2008, just before the Lehman Brothers Holdings, Inc. collapse, mortgage-backed securities and the convoluted—almost criminal—machinations behind them brought down the house. My choice of the term “house” is not meant in irony. Literally, Wall Street was indistinguishable from Las Vegas.

Wall Street in 2017 Is Like Pompeii in 79 AD

Wall Street, with its corruption from toxic debt and risky derivatives in 2008 was like Pompeii in August of 79 AD. The volcano Vesuvius had sent numerous signals in the form of earthquakes for at least 15 years before the big eruption of August 24.

But people of Pompeii decided to ignore them. Life was just too good in Pompeii. Until it wasn’t. It all evaporated in a flash. Residents suffocated from the gases. Because of the petrified ash that preserved their outlines and facial expressions, historians have grasped the full scale of the fear as they tried to save themselves. As someone interested in ancient Roman history as well as the history and patterns of finance, I was always struck by their expressions.

The faces of those who lost all their savings show the same expressions of bewilderment and desperation as the Wall Street bankers and brokers who just lost their jobs and savings. It’s all great until it isn’t. Everyone ignores the signs of trouble; it’s natural to do so. They ignored the signs in Pompeii. They ignored them in New York in October 1929, just like they did in September 2008.

They are ignoring the signs again in 2017. Superstitions aside, so many shock events seem to occur at the end of the summer or shortly thereafter. The nice weather—in the northern hemisphere – sets us up. It makes us less alert and we are more optimistic. That’s why the next six months—indeed, the stock market forecast for the next three months—is wrought with pitfalls.

There’s no guarantee you will identify most of the pitfalls. You would be lucky to get a handful right. But there are patterns that many seem to be overlooking, even though they are literally shouting the risks louder than Celine Dion can sing My Heart Will Go On. One of the ear-shattering risks that doesn’t appear to have caught investors’ attention plays a familiar tune: subprime.

In 2008, the subprime mortgage was the pothole that interrupted the bull market. In the summer or early fall of 2017, the pothole that sends the bull market of 2017 to a screeching halt could come in the form of subprime car loans. The sum total of such car loans at the end of 2016 was some $1.17 billion, up 70% from the lowest peak in 2010.

US car loans

Even worse is the fact that subprime auto loan debt has become a tradable commodity. Talk about alchemy. Subprime auto loan debt has produced some $5.9 billion in auto loan-backed securities. Meanwhile, fewer borrowers have paid off their auto loans early, sounding creditors’ alarm bells. American consumers are struggling to pay off their debts. (Source: “Another Warning Sign Flashes for Subprime Auto Loans,” Bloomberg, May 30, 2017.)

But auto loan debt is hardly the only sign of trouble. Household debt affects even families and individuals who have not purchased a car. U.S. households have some $12.73 trillion in debt. This is more than they did before the 2008 financial crisis. (Source: “US Household Debt Surpasses 2008 High, Hits Record $12.7 Trillion,” Zero Hedge, May 17, 2017.)

U.S. Households Are Back at It in Grand Style

U.S. households have returned to debt in a grand way. Some suggest that it’s not all that bad news. The theory for such an optimistic assessment is that the debt means households have cleaned up their accounts and can borrow again from their bankers. But, if they can borrow again; they can fall back into the same pattern of usury that fueled the 2008 crisis. Indeed, just about every major financial crash occurs when someone realizes that there’s too much debt.

Therefore, yes, analysts who suggest that the resurgence of household debt shows that consumers have generally improved their credit ratings to the point they can borrow again are not wrong. But, they are only pointing out one side of the problem. The fact that households are borrowing to such an extent means that they cannot afford to live their lives with the salaries they earn. They have to borrow to afford what have become necessities—not luxuries.

For example, owning a car in the United States is hardly a luxury. Unless you are a resident of Manhattan or another of the five boroughs in New York City—and possibly Chicago—public transportation is not convenient. People rely on their cars, sometimes reluctantly, to go from home to work and back. This has become one of the central paradigms of American society. Likewise, cell phones, computers, and the Internet are necessities. Many people rely on these tools to earn a living.

Yet, they are earning too little to be able to even afford their work tools. Meanwhile, such levels of debt, far from being an element of renewed optimism in financial institutions, suggest the U.S. economy is literally running on debt! The debt carries risks, evidently. Some have packaged those risks into instruments, which they sell, spreading that risk like a plague contagion in the Middle Ages. Eventually, it affects everyone and it could creep up to Wall Street in the next few months. All it takes is a trigger.

The Student Debt Time Bomb

Then there’s the problem of student debt as well. That’s separate from car loans or credit cards. Chronic student debt hurts young graduates even in the best of cases. That is, when they are lucky enough to find gainful and full-time employment after college. Student debt can prevent young people from buying a house, while always keeping them on the verge of defaulting. That’s after all what happened with the subprime mortgage crisis. The homeowners lost jobs or were earning too little to pay back their agreed mortgage amounts.

The cost of studying at American universities has erupted lately. It alone represents some 10% of the total debt amount contracted by households. It used to amount to three percent just a decade ago. And that’s when the subprime crisis erupted. This increase in indebtedness comes at a time, however, when the economy is supposed to be growing. But, really, it is not growing anywhere near the levels some had expected.

President Donald Trump appears not to have given up a three-percent GDP annual growth rate for the economy. There are few who still share that favorable sentiment. Let us consider for a moment the geopolitical risks that have been developing lately. These alone could spark a crisis given the extent of the overvalued stocks. Combine them with the extreme debt levels and the current market bubble, and the risk of the next stock market crash becomes clear.

There is the risk of a Trump impeachment and also the risk of terrorist attacks. There is the risk of the war in Syria worsening as the United States meddles in Syria, which could prompt Russian retaliation. There is a risk of terrorist events—and as seen with the Washington DC congressional baseball game shooting, terrorism can come from various sources. The struggle between Trump and the establishment has weakened the fabric of the U.S. society. The death of an American student Otto Warmbier, who returned to America after falling into a coma while held prisoner in North Korea, isn’t going to ease diplomatic relations between Washington and Pyongyang.

As for the economy, a strong correction may also be caused by Janet Yellen making too sudden a move, raising interest rates. Or it could begin in Europe as the European Central Bank might also act too hastily, raising interest rates prematurely. There is no shortage of even more critical financial concerns: the precarious debt sustainability of virtually all developed economic systems (public debt + corporate debt + private debt) and the structural fragility of the banking system with its derivative exposure of $227.0 trillion.

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