- Stock valuations are hovering around record highs.
- Hedge fund manager Mark Yusko told Business Insider we're merely in the middle of a bear market rally, and that stocks will fall 61% from current levels over the next 18-24 months.
- He also shared three types of stocks he's betting against right now.
- Visit Business Insider's homepage for more stories.
When the stock market's downfall arrives, it won't come all at once, Mark Yusko says.
"It won't be fast. It won't be overnight," the Morgan Creek hedge fund manager told Business Insider in a December 17 interview. "This is a two-ish-year kind of unwinding."
Nevertheless, the pain will be felt all the same.
With valuations sitting around record highs, Yusko says stocks are in the middle of a bear market rally, and the S&P 500 will see a 61% drop from current levels over the next 18-24 months.
His chief justification for the dramatic claim comes down to averages. He said that the market's valuation has gotten too far above fair value, has been there for too long, and is therefore unequivocally due for a meaningful pullback.
He cited the chart below from Advisor Perspectives, showing the fair-value average of the market over nearly 150 years. The red line represents the trend of the average fair-value price of the S&P 500, while the blue line reflects S&P 500 price action.
"The blue line, by definition, has to spend as much time above the red line as below the red line. That's how averages work," Yusko said.
"The blue line has been above the [red] line for 19.5 of the last 20 years. Only for a short period in 2009 did we get below fair value," he continued. "Today we're at 154% of fair value, which means just to get to fair value, which is going to happen at some point — I don't know when, but it is going to happen — that's about a 61% drop."
The main culprits of this overvaluation are of course mega-cap, index-leading tech firms like Amazon, Microsoft, Facebook, Apple, and Alphabet.
Yusko compared the flock of investors in them to those in companies like Cisco and Intel during the dot-com bubble, and said that today's market leaders will eventually also see downward price action as their PE ratios continue to climb.
But the fact that valuations are high is not enough alone to cause a sell off, Yusko said.
One of the potential triggers in the year ahead, he said, is the continued increase in the supply of equities — with the increase in IPOs and SPACs this year — without the increased demand to match the pace.
Other potential catalysts include what he called a high likelihood of a setback in the economic recovery process, further spikes in COVID-19 cases and corresponding lockdowns, and a reduction of share buybacks by firms, signaling their weak outlooks.
As for when such a dramatic downturn might begin, Yusko said he expects to see initial turbulence at the end of Q1, and then again in September toward the end of Q3.
"We'll probably have some challenging periods at the end of Q1, and then we'll probably get a little more stimulus, and as the economy slips back into a pretty bad recession and they realize the recovery's not going to be as robust as they thought," he said. "I think next year could be a really tough year."
But while it's difficult to pinpoint exactly when the 61% pullback will start, Yusko said he sees much of it happening in 2021.
"I'd say a good part of it happens in 2021, and the rest of it in 2022," he said. "I think it's an 18-24-month process."
How Yusko is preparing for the downfall — and 3 types of companies he is shorting right now
Given what he says is a very poor risk-to-reward ratio in the market, Yusko said he's planning to be less exposed to equities than he has been "in a long time," especially in terms of broader S&P 500 exposure.
However, he isn't bearish on the entire market.
Yusko said he recommends a diversified basket of cheaper assets like value stocks, as well as bitcoin.
Yusko also detailed the themes of his short positions, although he declined to name specific companies. One theme is a group of vaccine firms.
"We think there's a lot of hype around the vaccine. We think most of the vaccine companies are going to be busts. We think there's going to be a lot of pain," he said. "The way vaccines work is somebody wins and all the rest lose. It's not like there are 17 measles vaccines … I think there are some very overvalued companies in that sector."
He also said there is a small basket of firms he is shorting that he believes are fraudulent and which resemble companies like Wirecard, which he had shorted earlier this year.
"Wirecard was one of our big successes this year," he said. "Wirecard became one of the biggest companies in the DAX and then everybody bought it and it went down 99%. There could be some companies in the US that are going through that."
Finally, he said he has short positions on some traditional retail firms which he says stand to get crushed by Amazon. He added that he's decreased the number of these positions this year because of short squeezes in November and December despite lackluster fundamentals.
"One of our themes has been what we call Amazon roadkill, which is the death of traditional retail," Yusko said. "We're in this weird environment right now where there have been these massive short squeezes in November and December, and so we have less short exposure today than we did three months ago or six months ago…But traditional retail, long-term, is going to be challenged."
Yusko added that he's not short on any mega-cap tech companies yet, although he "really" wants to be. He said he plans to wait until he can act with a higher degree of certainty.
History as a guide
Yusko is certainly outnumbered by those who are bullish on the market's trajectory in 2021.
Just about all the main players on Wall Street, including the biggest investment banks, see an upward path for the S&P 500 next year.
But for those skeptical of the 61% drop he is predicting amid a financially accommodative environment, Yusko points to the depths of prior sell-offs.
"In 2000, everybody said Greenspan, the Fed, was going to save the day," he said. "But eventually the tech bubble burst and the market went down 50-plus percent. It actually went back to fair value. So the Fed didn't save the day then."
He continued: "Then in 2008, everybody said 'Bernanke, he's got our backs, the Fed's got our backs.' And the global financial crisis happened and the market went down 58% peak-to-trough."
He added that the Federal Reserve's intervention earlier this year to revive financial markets was a temporary fix, and that the recovery amounted to merely a rally in a greater bear market that began in March.
"This time the market started to crack, it was down 38% and the Fed rode to the rescue and everyone said 'Oh, see, they saved us!' Well, yeah, kind of. I mean, there's no question that they stopped the first descent. But bear markets can be really insidious.
He continued, "If you go back and look at the bear market from 1929 to 1932, it took three years, the market went down 48%, it bounced up 48%, then it went down another 60% to trough down 84%. And bear market rallies are very common. Now this one's a little larger than the average bear market rally, but not out of character."
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