Here’s Why A Big Bad Bear Suggests The Stock Market Could Crash 50%

Where interest rates go, so do the stock markets.

Overnight, the US Federal Reserve indicated it was willing to continue raising interest rates to curb inflation, but was wary of boiling it over, potentially sending the US economy into recession.

“…there are signs that some officials are getting a little nervous that they might go too fast and eventually have to change course,” James Knightley, chief international economist at ING, said in a note on Market overview.

Initially, the markets liked what they saw, looking ahead to the days when interest rates would be cut.

But then a dose of reality hit, as traders recalled, before then it will still take some super-sized rate hikes to contain the 8.5% inflation.

The Dow Jones Industrial Average Index (DJX: .DJI) broke a five-day winning streak, with 170 points or 0.5%. The NASDAQ-100 Index (NASDAQ:NDX) fell 164 points or 1.3% as traders took gains in growth stocks.

Of course, the S&P/ASX 200 Index (ASX: XJO) followed the lead in US markets and was lower in early afternoon trading on Thursday, as coal and oil inventories rose to offset declines in technology and gold stocks. Never a straight line…

Has the market bottomed out?

The big bad bears at Bank of America are thinking about markets have not bottom, despite the Dow gaining 17% since its June low and the ASX 200 gaining a more modest 10%.

“Only 30% of our bull market signposts [things that happen before a market bottom] activated versus 80% or more in past market bottoms,” the bank’s equity and quantitative strategist Savita Subramanian said in the AF.

Based on his ‘rule of 20’, the price-to-earnings ratio (P/E) should be 11 and not 20.

At a time when profits are falling and therefore P/E ratios are rising, under the Bank of America rule, the market could fall by 50% from here.

A fall of that magnitude would entail some capitulation. I like to take the other side of that gamble and say markets will not 50% fall.

A glass half full perspective

I am always a glass half full person when it comes to the stock market. My ‘Rule of One’ (which I am) is that when the markets rise, I’m glad my existing portfolio wins. When the markets fall, I’m happy too, because it allows me to buy some companies cheaply.

Which reminds me of a quote from billionaire investor Charlie Munger…

“If you want to stay in this game for a long time, which is the way to do it, you better be able to handle a 50% drop without worrying too much about it.”

Take that, Bank of America!

Cheap ASX shares ahoy

Finding cheap stocks among the ASX 200 is no small feat.

Commonwealth Bank of Australia (ASX: CBA) on a P/E of 18? No thank you.

CSL Limited (ASX: CSL) at a P/E of 40? No thank you.

Mega-cap mining stocks like BHP Group (ASX:BHP) and Fortescue Metals Group (ASX:FMG) to be cheap and traded on bumper, fully franked dividend yields, but this is the top of the cycle, historically not a good time to buy mining companies.

That said, the price of Fortescue stock has barely set the world on fire in the past 12 months, dropping 11%, lagging the return of the ASX 200. The market may already have “topped the cycle”. “priced into the share.

On a trailing basis, Fortescue shares trade at a fully franked dividend yield of more than 15%. That yield will fall once the iron ore giant reports its full-year results, including its final dividend, on Monday, August 29, but will likely still remain high.

A play on Fortescue is a play on the iron ore price, that is a play on China, which is also partly a play on the global economy. If only stock selection was easy…

Where to go?

When looking for cheap stocks, I prefer the small part of the market. Not only can you find companies that are growing quickly, but they are often overlooked by fund managers because they are either too small to move the knob and/or too illiquid to buy and sell. All of this means that small businesses and microcap companies can trade at dirt-cheap prices.

As I mentioned yesterday, one of my microcap holdings – MSL Solutions (ASX: MSL) – announced the results today. The leading provider of SaaS technology to the sports, leisure and hospitality industries reported massive revenue growth of 37% and a 70% increase in earnings before interest, taxes, depreciation and amortization (EBITDA), both well above expectations.

Frustrating for shareholders and management, MSL Solutions stock price barely rose in trading on Thursday, rising just half a cent or 3% to 17 cents, a long way from its 52-week high of 28 cents.

Microcap investing can be a game of patience. And one that requires diversification, if only to alleviate the tedium of waiting for the market to recognize what you think the results are worth.

To avoid getting bored, I’ve put in many more irons in the fire, including a microcap that’s trading just 2.5 times faster than the recently upgraded EBITDA forecast. I hope the results will be greeted by more than a passing yawn.

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