What return to expect for next year

 Wall Street has been begging the Fed to cut interest rates for months, if not years. Now the rate cut is coming. Will this rate cut be good for the stock market? At least the current market performance is clearly expecting this. But history is painting a different picture!

As you may have already known the yield curve inversion situation that has been ongoing for two years, with short term rate being higher than the long term rate. This has been highly predictive for a recession to come. But actually the more precise timing signal for the upcoming recession is when the yield curve un-inversion, i.e. when the long-term rate is moving higher and become more than the short-term rate. See below the historical recessions (the grey bars) that were always preceded by a yield un-inversion (the black line moving above the 0 level). 

  

When this happens, a recession will follow soon and the average stock return is quite poor with a median of around -10%. Keep in mind this is the median decline and it can be much worse. For this time, I bet we will like see a lot worse stock market in the next 1-2 years.

 

Here are a few key factors that will contribute to the scary prospects in the stock market:

High valuation:  One way to understand their nosebleed valuations is to look at the S&P 500's price-to-sales ratio. The only other time this ratio was so high was back in late 2021... right before stocks went on to fall 25%.

Another measure of stock market valuation we like to use is the cyclically adjusted price-to-earnings ("CAPE") ratio. This compares the current price of the S&P 500 with the past 10 years of earnings to get a view that extends past a single business cycle. By that measure, stocks have only been more expensive than today twice in the history of the U.S. market – at the end of 2021 and during the dot-com bubble. 

Then we have a phenomenon of a highly concentrated stock market, meaning the indexes are highly dominated by only a handful of super mega stocks with very high valuations. See below the top ten biggest stocks and their weight in the three major stock market indexes, ranging from 25% to 38%. This will put the overall market in a very vulnerable situation since they will suffer greatly when these mega stocks starts to fall. Don't forget, these same stocks had plunged over 50% during the 2020 market correction.  

 

 We should also not forget the extremely euphoric mood the investors have for now. This is a contrarian indicator, which often occurs when the market is at its top, not the bottom. 

Of course, there are many more risks facing us such as high debts, increasing bankruptcies, spreading geopolitical conflicts etc. Taking into consideration all these risks, I don't think it is unreasonable to expect we will likely see a much worse market correction, if not a depression.