Transcription
Leading up to the peak of the stock market in 1929, margin debt reached about $10 billion. This was the main form of leverage in the stock market at the time. That was equal to roughly 9% of US GDP back then. An absolutely massive buildup of leverage.
But what if I told you that we actually have more leverage built up in the system today than in 1929. Margin debt in 2025 has risen to nearly 1.1 trillion. This is the biggest ramp up in leverage we've seen since 2000, 2007, and even 2020. Now, on its own, this is only about 3.5% of GDP, so less than in 1929. But if you add on top of that $135 billion in leveraged ETFs, and another $5 trillion in equity linked derivatives like options contracts, CFDs, and swaps. Altogether, we end up with roughly 20% of US GDP being some kind of leveraged financial instrument. That's more than double the level that we saw at the peak of the stock market in 1929.
It has now been 15 years since the last prolonged economic downturn. Since 2009, the US economy has been for the most part stable, and stock market earnings have been growing steadily over this period of time. This has been a macroeconomic backdrop that has allowed investors to take on more and more leverage without really facing any major consequence. But what would happen if the tide were to turn? What would happen if investors lost confidence in the economy and stock market earnings began to decline in a consistent manner? Let's take a look at that.
By the way, we had a lot of people ask us to extend the discount that we're doing on our service for our fth birthday. So, we decided to extend it by a couple of days to make sure that everyone can use it. So, if you want access to a full year of our premium macro trading service for a fraction of the usual price, this is your last chance to get it. I promise you will not regret it. You'll be joining thousands of satisfied clients at any given point.
The US stock market is simply a reflection of the earnings that the stock market is generating times the price that investors are willing to pay for these earnings. Something called the PE ratio. Today, for example, the S&P 500's earnings per share stands at $294, while the PE ratio of the stock market stands at 22.8. And that gives us the precise level of the S&P 500 index of 6,73 points. If we can figure out the impact that an unwind of leverage during an economic recession would have on these numbers, we can make an educated guess of what would actually happen to the S&P 500 index.
So, let's start with the earnings. A good chunk of these S&P 500 earnings simply comes from US consumer spending. And we happen to think that this is something that could be particularly vulnerable if a recession were to occur. Today, roughly 50% of consumer spending in the US comes from high-income Americans. So that's the top 10% of the US population. This is the highest proportion going back to the 1990s. And it helps explain the resiliency of the US stock market over the last few years during a time where most people have felt like they're not keeping pace with the rising cost of living. This rising proportion of spending coming from the top 10% has been supported by extremely strong stock prices over this period of time.
This line here shows us how much the stock market makes up of total household assets. So in other words, how exposed the average household is to the US stock market. Back in 1990, US households had a 5% allocation to stocks. Today, it sits at a staggering 40%. As we've seen the stock market rise, the exposure of households to stocks has risen, making people feel wealthier and ultimately leading to higher levels of spending, especially for the ones who hold lots of stocks, which tend to be in the top 10%.
Now, this strong stock market has provided fuel for earnings to remain resilient. But if an economic recession were to occur, it could leave earnings more vulnerable than usual. And this is not just a theory that we're throwing out there. It's a well-established phenomenon supported by academic research called the wealth effect. It suggests that as the stock market rises, people feel wealthier and hence spend more, stimulating the economy. The inverse wealth effect is when the stock market falls, people feel poor and stop spending, which tends to be a drag on economic growth. Considering the high level of exposure that households have to stocks, it's safe to assume that today's wealth effect is stronger than usual and that a falling stock market could be a significant drag on earnings.
We can see here on this chart all of the draw downs in stock market earnings and various recessions going back to the 1960s. On average, across all recessions, we've seen an earnings draw down of roughly 30% during a typical downturn. The inverse wealth effect today could quickly turn a garden variety 30% earnings draw down into a 40% draw down. If this were to happen tomorrow, the S&P 500's earnings per share would decline from 294 down to 206. If we assume that the PE ratio of the stock market remains unchanged, that would simply translate into a 40% decline in the S&P 500 index, taking it down to 4692 points.
But economic downturns and market crashes very rarely play out like this. Today, the PE ratio of the stock market of 22.8 is historically elevated. It has been steadily rising since the great financial crisis, which has been a reflection of stable financial conditions and steady economic growth. With the stock market steadily growing its earnings, the buildup in leverage that we mentioned earlier has also likely contributed to this rise in valuations. Leveraged ETFs, options, CFDs, and other financial instruments have allowed investors to ramp up their exposure to stocks bidding up prices to higher levels than usual. If we were to enter a recession, we could expect that a lot of this would reverse and that the PE ratio could actually contract, which was the case in the 2001 recession, in 2008, and briefly in 2020.
Going back 100 years, the average contraction of the S&P 500's PE ratio during a recession has been roughly 30%. Just a typical 30% contraction in the stock market's PE ratio would take it back down to 15. Now, in 2009, when the leverage in the banking system unwinded, the S&P 500's PE ratio reached 10. So, we actually think that in the event of a true recession and a loss of confidence in the stock market, the S&P 500's PE ratio could contract by 40%, taking it down to roughly 13.5.
So, let's come back to our formula once again. A 40% decline in earnings and a 40% decline in the PE ratio of the stock market would translate into approximately a 64% decline in the S&P 500 index that would be taken down to 2,818 points. If we look at a chart of the S&P 500, a scenario like this would take the index back down close to its coid9 bottom.
Now, before some of you rush to the comment section to accuse us of spreading fear, there are a couple of things worth noting. Such a scenario is by no means a certainty. There is no such thing as a guarantee in financial markets. And this definitely does not mean that you should sell all your stocks right now. But the truth is the risks of such a scenario taking place at some point over the next few years are very much present and history does show that this has happened before. Completely dismissing this possibility means that you're not putting in place a plan in the event that this actually does happen. Not planning in advance is what investors have typically done during times of market panic, which we know leads to irrational decision-making and financial pain. You might think you're different, but you're not. In the heart of the panic, you're going to hear all sorts of theories, all sorts of noise that will lead you in the wrong direction. You need to know exactly what you're going to do ahead of time if something like this were to happen.
And there are really only three strategies that you can adopt to successfully navigate this kind of scenario. Firstly, you can just not care about the price action and keep on dollar cost averaging periodically in the US stock market whether the index is going up or down. For most people, this is the safest approach. It ensures that you're steadily investing into the stock market regardless of what happens with the economy. Having a periodic investment plan will prevent you from making rational decisions.
The second approach is one based on valuations. This is more the Warren Buffett style of investing where you determine your allocation stocks based only on how expensive they are. Brookshire Haway, Warren Buffett's holding company, currently has a record cash allocation today given the high valuations. For example, this is not really market timing. It just acknowledges that at certain prices stocks are attractive and at certain prices stocks are not attractive. The risk that you need to be aware of if you're adopting the strategy is that the stock market can hypothetically remain expensive indefinitely, which has kind of been the case since 2020. But if the scenario we laid out earlier did materialize and valuations drop significantly, it would mean you have significant dry powder to allocate to stocks when they are at a cheaper level.
The final approach, and probably the most controversial of them all, is to time the market. Now, you've probably heard the saying, timing the market is impossible. But the truth is, people usually call something impossible when they haven't figured out how to do it themselves. We time the market all the time with our members at Bravos Research, and we also show them how to do it. History shows it's not rocket science, nor does it require a crystal ball, but it does require you to follow the market closely, be flexible, unbiased, and understand how markets work. Our trading strategy revolves around being long on the market when conditions are favorable and being out of the market when conditions are not favorable. Currently, for example, we are long on the market and we've been so since May.
Regardless of what strategy you pick, the important part is that you stay unemotional and confident in your process in the event that we see such a scenario happen. Again, I strongly recommend you take advantage of the discount that we're doing to celebrate our fifth anniversary at Bravos Research. Since the beginning of the year, we've had some pretty crazy trades on semiconductor stocks, on gold, gold miners, industrial stocks. We're focused on being exposed to the strongest parts of the market. That is how you generate real outperformance in the market. If you're interested, go to braavosearch.com. You won't regret it. Thank you for watching.