Could a Credit Bubble be About to Burst on Wall Street?

The current state of the credit markets is giving a false sense of security, driven more by the booming demand for limited supply rather than economic fundamentals. This could be setting the stage for a significant reckoning.

Experts like Mark Spitznagel warn that we are in the 'greatest credit bubble in history.’ According to him, this bubble is fueled by years of artificially low interest rates and excessive liquidity. The situation is evident in high levels of corporate and public debt, which are seen as unsustainable in the long term. The burst of this credit bubble could lead to a severe market crash. This event would potentially drag interest rates to new lows.

Source: Deloitte

The Warning Signs

Spitznagel isn't alone in his concerns. Indicators such as the yield curve inversion—a historically reliable predictor of recessions—have been flashing warning signals for some time. The U.S. 3-month yield has been higher than the 10-year yield for 22 months, marking the longest inversion in history. According to Jim Bianco of Bianco Research, it typically takes around 66 days after the yield curve disinverts for the economy to crack.

Adding to these concerns is the rising debt burden across various sectors of the economy. U.S. non-financial corporations have accumulated a record $13.7 trillion in debt, while total global debt hit a record $315 trillion in the first quarter of 2024. Much of this debt is government-related, but corporate and consumer debt levels are also alarmingly high, raising questions about sustainability.

Scenarios to Consider

While the warning signs are concerning, not all analysts are on the same page. Some argue that the U.S. economy remains resilient and can prevent a major downturn. Proponents of this view highlight the possibility of a soft landing where inflation is gradually brought under control without triggering a recession.\

Others believe that even if a bubble exists, it may continue to inflate before bursting. Bubbles tend to reach euphoric highs before collapsing, which means that the market could still see gains in the near term before any potential downturn. For retail investors, he advises patience and caution, suggesting a focus on basic S&P 500 index funds and maintaining a safety margin to avoid being forced to sell during market lows.

Navigating the Stock Market Amidst Declining Rates

Historically, Federal Reserve rate cuts have signaled prosperous times for equities, as lower rates make equities more attractive relative to bonds. This pattern has held true for the better part of four decades (refer to the chart). During these periods, the Fed typically began easing monetary policies before economic conditions deteriorated into a recession, often spurring significant rallies in the equity markets.

Fed Chair Jerome Powell has hinted at potential rate cuts starting from September 2024. The lower rates would reduce the discount rate applied to future earnings, effectively increasing the present value of stocks. Some analysts predict that this could add approximately one multiple to the S&P 500's valuation, assuming long-term rates and inflation continue to decline as expected.

Maxim Manturov, head of investment research at Freedom24, has a positive outlook for the equity market going forward:

Concerns about a potential stock market crash and bubble have a place. Nevertheless, it makes sense to maintain an optimistic view of the market based on both fundamentals, such as earnings growth, Fed rate cuts and a booming technology sector, and other factors, especially in the longer term.

In a normal scenario, following typical S&P 500 cycles and demographic trends, we can expect the S&P 500 Index to rise significantly by the end of the decade. This forecast is based on continued earnings growth and market valuation ratio. Additional factors include earnings growth and expanding price-to-earnings (PE) ratios. While annual PE increases may seem ambitious, they are justified by the resilience demonstrated by businesses during the COVID-19 pandemic. Companies' ability to maintain profits despite severe economic shocks emphasizes their resilience, guaranteeing a higher PE ratio than pre-pandemic levels.

Balancing Risks and Opportunities

While the prospect of rate cuts is undoubtedly positive for equities, investors should approach the market with caution. Overvaluation is not the only risk on the horizon. Factors such as a looming recession, geopolitical tensions, and potential disruptions from the U.S. election could all weigh on market performance.

To navigate these uncertainties, many experts recommend a balanced portfolio approach. While growth stocks, particularly in the tech sector, have driven much of the market's gains in recent years, there is a growing case for diversifying into value stocks and international equities. This strategy can help mitigate risks associated with overvaluation and provide exposure to markets that may be less affected by U.S. monetary policy​.