Lionized in the film The Big Short for his audacious bet against the housing market prior to the Great Recession, hedge fund manager Michael Burry is again taking to social media to broadcast his latest warnings. This time, Burry sounded the alarm on a two-part cycle: first comes the multiple compression, then comes the earnings compression. Should investors be concerned?
In a since-deleted tweet, Michael Burry stated that adjusted for inflation, the S&P 500 index suffered 25% to 26% loss in the first half, whereas the technology-centric Nasdaq dipped around 34% to 35%. Further, the cryptocurrency sector suffered a catastrophic loss, shedding almost two-thirds of its total market value. Burry, who is the owner of Scion Capital Management, warned the erosion provided evidence for multiple compression.
However, Burry reckons the broader market correction is “maybe” only at the halfway point. In his view, what follows next is earnings compression, which would really grab Wall Street’s attention. Here’s a quick breakdown of his warning to retail investors.
The First Act of Multiple Compression
To best understand the concept of multiple compression, you should recognize the two primary reasons why stocks move higher. First, investors expect underlying earnings to rise. Second, market multiples or the premium to acquire a future streaming of earnings increase.
With multiple compression, investors are no longer willing to keep paying ever-rising premiums on stocks. Therefore, their share price declines – even if nothing fundamentally has changed at the moment with the underlying companies.
What would cause multiple compression? In the new normal, the Federal Reserve let loose the monetary spigot, making an easy-money environment even easier. This dynamic incentivized multiple expansion as money parked in bonds or similarly safe vehicles would shed their returns in real terms. Indeed, easy money spiked cryptos for the same reason.
However, the unwinding of risk-on stocks and assets demonstrates the logical reaction when the economic and monetary environment reverses course. But as Michael Burry warned, this compression is only the first act.
Michael Burry Warns About the Second Act
While the term sounds ominous, multiple compression represents the natural ebb and flow of free-market forces. During some phases, investors are willing to pay a premium for specific assets; in others, they anticipate a discount. Eventually, the market finds an equilibrium, only to start up the process all over again.
However, what Burry is concerned about is a cycle, if you will, of compression. Currently, the market is experiencing volatility stemming from investors’ unwillingness to pay previously acceptable premiums. However, fundamental vulnerabilities may represent the root of the next downturn.
In other words, earnings compression addresses the first reason why stocks move. Moving forward, investors may no longer believe that the companies’ earnings will rise and are therefore exiting the market. That would be the second act of the bearish cycle where investors no longer have confidence that corporate America can ride out the incoming economic storm.
It’s All Connected
Earlier, Michael Burry warned about the bullwhip effect, which represents the financial consequences of retailers overstating their future demand profile and subsequently ordering too much inventory. In his tweet, Burry referenced Target (NYSE:TGT), which is refunding certain products while asking customers to keep them.
Although this bizarre circumstance can be a win-win for the fortunate customer, it points to severe fundamental dilemmas affecting retailers and perhaps other industries. Therefore, a much more potent downturn could be awaiting investors, explaining Burry’s torrent of activity lately.
On the date of publication, Josh Enomoto held a LONG position in BTC. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.