Michael Burry has been thrust back into the spotlight in recent weeks. The former hedge fund manager who rocketed to fame for his contrarian bets anticipating the 2008 housing market collapse has issued another dire warning.
In a recent interview, Burry cautioned investors against getting complacent during the current market rally. He sees eerie echoes of market bubbles past and believes the US stock market is primed for a devastating crash in 2023.
Burry highlights that despite escalating economic woes – including negative GDP prints, four-decade high inflation, and declining corporate earnings – investors keep flooding back into stocks on down days. This seemingly unwarranted dip-buying optimism concerns him.
In Burry‘s view, current conditions mirror those preceding past painful market drawdowns. So what is driving his bearish outlook? And could his warning prove prescient once again or is the latest rally sustainable?
Burry‘s Track Record of Seeing Around Corners
Burry exploded onto the scene as one of a rare few investors who spotted the US housing bubble before almost anyone else. He famously shorted the overinflated housing market prior to 2008, a trade immortalized in Michael Lewis‘ book The Big Short.
But Burry also correctly predicted:
- Soaring post-lockdown inflation
- The 2021 meme stock mania
- The boom and subsequent crash in Bitcoin
So when Burry speaks, investors smartly tune in. His non-consensus views unveil risks hidden in plain sight. And his latest warning centers on excessive investor enthusiasm pushing markets detached from reality – a setup he recognizes from past manias.
Let‘s analyze some of the chief concerns driving his bearish bias.
Stock Market Inflows Stay Elevated Despite Troubling Fundamentals
While company earnings limp along and economic growth contracts, the stock market continues to see inflows. According to Burry, the S&P 500 experiences an average increase of +1.28% in the trading session directly after down days of at least -1%.
For context, between 1985 to 2021, the index historically bounced just +0.12% after such falls. So stocks are recovering over 10X more vigorously from sell-offs than the norm.
To Burry, this conveys an unwarranted "buy the dip" mindset that reeks of investor complacency – the type seen before bubbles pop. It suggests holders believe any downturn represents a discounted buying opportunity, despite mitigating data screaming caution.
Chart showing rising returns in the S&P 500 the trading session after >1% down days. (Source: Michael Burry)
Additionally, Burry notes that:
- -30% market drawdowns used to happen once every few years – now over a decade has passed without one
- Retail investors opened 30 million new brokerage accounts since 2020 – bringing horrific memories of the influx of novice traders during the 2000 dotcom bubble
Newer investors flooding the market, coupled with this "buy all dips" conditioning, leaves markets primed for a sentiment swing if the backdrop keeps worsening.
How Inflation and Rates Could Spark a Downturn
While investors cheer each market bounce, inflation continues gnawing away at consumer wallets. Rising rents, fuel costs, healthcare, and food prices have sent the cost-of-living index soaring.
This has eroded consumer savings built up during lockdowns. After peaking above 33% in April 2020, the US personal savings rate has slid back near 6% – not leaving much leftover cash to propel further market gains.
The US savings rate has fallen significantly over the past two years (Source: Credit Writedowns)
And with the Fed funds rate set to pass 5% in 2023 as the FOMC keeps hiking aggressively to tame inflation, loan and credit card rates will head even higher. This spells less discretionary income available for stocks.
As Burry told Bloomberg:
"Rising rates, to a level where savings yields are competitive, will lead to a level of asset destruction that the Fed and Treasury need to stem with rate cuts, but cannot with credibility promise."
The dual impact of inflation and rising borrow costs may represent the pin poised to burst the market bubble if consumers pull back.
Risks Rise as Stocks Trade at Elevated Historical Valuations
Stock prices relative to corporate earnings paint the full picture of how overstretched markets have become. By comparing current ratios versus past cycle peaks, we can gauge the risk of a crash.
The CAPE ratio (cyclically adjusted PE ratio) developed by Nobel laureate Robert Shiller averages earnings over 10 years to smooth out short-term profit fluctuations. This gives a reliable historical barometer of relative valuations.
Chart showing the CAPE ratio by year dating back to the 1880s (Source: Forbes)
After hovering in the high 30s for much of 2022, the CAPE ratio has eased to 32.7x – a level only exceeded during the rally preceding the Great Depression and the dotcom crash. This signals severe overvaluation.
Additionally, NYSE margin debt has slid to $625 billion – but still hovers above peak levels reached before prior collapses like 2008. And various sentiment surveys show 4 in 5 individual investors describe themselves as bullish – a worrying sign of groupthink.
Across many metrics, markets show the irrational exuberance associated with final manic melt-ups before the music stops.
Burry wonders whether the current rally is simply the latest head-fake suckering investors in before the real capitulation.
Investment Implications If Burry‘s Warning Proves True
The current market outlook certainly appears hazier than the ebullient investor sentiment suggests. Slowing economic expansion, declining earnings growth forecasts, and rate hikes stretching stock valuations all lend credence to Burry‘s caution.
If inflation persists above target levels despite the Fed getting more aggressive, profit margins could shrink further. And cash-strapped, debt-burdened consumers may finally tighten purse strings – triggering the overdue market correction.
So while timing exactly when sentiment shifts remains impossible, preparing prudently seems key. Here are actions investors can take to brace against potential storms ahead:
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Hold higher cash balances – Keeping dry powder protects against having to sell assets at a loss during market turmoil. Cash also provides flexibility to snap up bargains after crashes.
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Stress test your portfolio – Assess how your holdings might perform through various downturn scenarios. Trim vulnerability to high-valuation momentum stocks likely to see big drawdowns.
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Hedge with put options – Purchasing put options on market index ETFs like SPY helps buffer portfolios without exiting core positions.
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Scale into defensive assets – Allocate a portion to assets like consumer staples, utilities, mega-cap tech, and short-term bonds that typically weather market storms better.
While I don‘t believe drastic actions like liquidating portfolios are warranted yet, taking prudent precautions seems sensible at this stage of the cycle.
Within equities, back-to-basics investing in profitable, dividend-paying companies with pricing power has the best risk-reward profile entering 2023. Outside of stocks, short-term bonds with elevated yields now offer decent carry. And with volatility anticipated, keeping sufficient cash and gold positions makes sense to enable staying power through messier markets ahead.
Conclusion: Likelihood of Downturn Rising but Timing Unknown
Michael Burry‘s latest warning highlights legitimate reasons to doubt the staying power of the current market rally. While no forecast model can pinpoint exactly when sentiment will crack, the odds of a downturn seem to be rising.
However, other strategists point to still-resilient household balance sheets outside of lower-income consumers. Corporate profitability also remains healthy overall besides struggling tech giants. And historically markets have run for some time even once conditions appear overstretched.
Yet it pays to remember market crashes often take most investors by surprise despite warning signs brewing quietly in the background. Very few predicted the 2000 dotcom bubble bursting or the 2008 housing market collapse until it was too late. So keeping watch for signs of excess and safeguarding against downside does seem prudent at this stage.
In my assessment, while the near-term outlook remains positive overall, risks appear skewed to the downside as 2023 progresses. Economies look likely to weaken further, valuations still demonstrate over-confidence, and sentiment feels stretched.
So while I wouldn‘t advocate market timing, this is a juncture favoring caution over blind optimism. The window for protecting gains already made could close quicker than most investors anticipate if macro conditions keep worsening.
Burry‘s warnings may prove early as they did prior to 2008‘s meltdown. But given signs of instability, having modest expectations and bracing for storms seems the best mindset entering 2023. Burry‘s prescience before previous crashes commands respect for his latest bubble warning.