It Has Begun: The Early Signals of the Next Market Downturn.
In this issue:
It has begun: housing, credit and free cash flow signal the next market downturn
Why value, small-cap, and momentum stocks no longer earn excess returns… and what’s the solution
A framework for contrarian investing
1. It has begun: housing, credit and free cash flow signal the next market downturn
Peak Financial Investing podcast, Episode: Housing, Credit and FCF Have Cracked ... Stocks Are Next (Nov. 11, 2025)
TLDR:
Three leading indicators are flashing warning signs simultaneously: housing market stress (rising inventory, falling sales), credit market deterioration (rising delinquencies, tightening standards), and corporate free cash flow compression (companies burning cash despite strong reported earnings)
These indicators typically lead stock market declines by 6-12 months, giving investors time to adjust positioning before the crowd panics
The key is distinguishing between noise (temporary weakness) and signal (systematic deterioration) – right now, multiple data points suggest signal, not noise
Markets don't crash out of nowhere. They crack first, slowly, in places most investors aren't watching. Housing weakens before stocks fall. Credit deteriorates before defaults spike. Corporate cash flow compresses before earnings collapse. Right now, all three are showing concerning signs.
These aren't reasons to panic – they're reasons to pay attention. Leading indicators give you time to adjust positioning before problems become obvious to everyone.
Housing as the canary
Housing markets lead the economy and stock market by 6-18 months. When housing weakens, it signals trouble ahead. Right now, several concerning trends are emerging. First, inventory is rising while sales are falling (up 33% from 2024) – a classic pattern before recessions. Months of supply (how long it would take to sell current inventory at current sales pace) is increasing nationally, indicating oversupply relative to demand.
Second, mortgage applications are declining despite relatively stable rates. This suggests demand weakness isn't just about affordability – it's about buyer confidence in economic conditions. When people worry about job security or economic outlook, they delay major purchases like homes.
Third, home builders are getting more cautious. When home builders stop breaking ground on new projects, they're signaling that they see softening demand ahead. Housing starts (new construction, down 8.5% MoM and 6% YoY in August) are a forward-looking indicator because builders have to forecast demand 6-12 months out.
Here's why this matters: housing creates enormous multiplier effects. When housing is strong, people buy appliances, furniture, lawn equipment, and make home improvements. When housing weakens, those categories suffer too. This ripples through retail, manufacturing, and employment.
For example, it’s telling that shares in Owens Corning, a leading maker of roofing and insulation, have dropped 50% over the past year.
Credit markets telling a story
Credit markets often see problems before equity markets because lenders care about downside risk while equity investors focus on upside potential. When credit markets tighten, they're signaling increased risk that equity investors might be ignoring.
Several credit indicators are flashing warnings. First, commercial credit card delinquencies are rising, particularly among sub-prime borrowers, and are currently at their highest rates since 2012. When consumers start missing payments, it indicates financial stress that will eventually reduce spending, which hurts corporate revenues and earnings.
Second, auto loan delinquencies have reached levels not seen since 2010 (a factor of rising car prices and interest rates, which combine for ballooning auto payments). Cars are essential for most Americans to get to work, so auto loan defaults signal serious financial distress. People prioritize car payments over almost everything else except housing. When auto defaults rise, it means a significant number of households are in real trouble.
Third, bank lending standards are tightening across categories: mortgages, auto loans, credit cards, and commercial lending. “Banks reported tighter lending standards and weaker demand for commercial and industrial loans to firms of all sizes during the second quarter of 2025” (ABA Banking Journal, referencing the Fed’s Senior Loan Officer Survey).
When banks get more cautious about extending credit, it's because their internal risk models are showing increased probability of defaults. Banks have better information than public investors about borrower health.
The free cash flow illusion
This might be the most important signal: reported earnings look fine, but free cash flow is deteriorating. Free cash flow is earnings minus capital expenditures and changes in working capital – it's the actual cash a business generates that can be returned to shareholders or reinvested.
Many S&P 500 companies are reporting solid earnings growth while burning cash. How is this possible? Accounting earnings and cash flow can diverge for legitimate reasons (timing of receivables, inventory builds, etc.) or questionable ones (aggressive revenue recognition, understating future liabilities, etc.).
When free cash flow consistently trails earnings, it's a red flag. It means either the business model requires more capital than the accounting suggests, or management is playing games with earnings to meet expectations. Either way, it's unsustainable.
[Editor’s Note: Large CAPX spending may also be related to AI-related investing because companies are seeing growth areas to invest in, so it could be justifiable]
Putting the pieces together
Individually, each of these signals could be noise. Housing market corrections happen. Credit cycles ebb and flow. Free cash flow can temporarily lag earnings. But when all three deteriorate simultaneously, it typically precedes broader economic and market problems.
The pattern looks like this:
housing weakens first (consumers see it and pull back) → credit deteriorates next (financial stress builds) → free cash flow compresses (businesses feel the impact) → reported earnings finally decline (markets wake up) → stock prices adjust (often violently once the full picture becomes clear).
Right now, we're somewhere in the middle of that sequence. Housing and credit are weakening. Free cash flow is compressing. Reported earnings and stock prices haven't adjusted yet.
How to adjust positioning
The data don't say "sell everything tomorrow." They say "be careful, increase quality, reduce leverage, and favor defensive positions." Practically, that means several things for portfolio construction.
First, increase cash positions moderately – not to zero equity, but perhaps to 10-15% cash versus the usual 2-5%. This provides dry powder if markets decline and creates optionality.
Second, favor quality over value. When markets decline, high-quality companies with strong balance sheets, pricing power, and consistent cash flow hold up better than deeply discounted companies with questionable fundamentals.
Third, reduce exposure to consumer discretionary and housing-related sectors. If the warning signals are right, these sectors will underperform. Shift toward healthcare, utilities, and consumer staples – boring businesses that people can't stop using even when times are tough.
Fourth, consider hedging strategies like long-dated put options on broad market indices. The cost is relatively low when volatility is moderate, and they provide valuable protection if the warnings prove correct.
2. Why value, small-cap, and momentum stocks no longer earn excess returns… and what’s the solution
The Blunt Dollar podcast, Episode: Rob Arnott: The Death of Risk Premium (And What Comes Next) (Nov. 3, 2025)
TLDR:
Rob Arnott argues that traditional risk premiums (value, small-cap, momentum) have stopped working because everyone knows about them and trades them systematically
When premiums become "common knowledge," they get arbitraged away
The solution: look for risk premiums in areas that are uncomfortable, illiquid, or socially unpopular (places where capital is still scared to go)
Rob Arnott, founder of Research Affiliates, has spent decades studying what actually drives returns. His latest work challenges a pillar of modern portfolio theory: that certain risks reliably deliver excess returns over time. Value stocks, small-caps, momentum strategies – these "factors" have been the foundation of quantitative investing for years.
Arnott's uncomfortable conclusion: most of them have stopped working. And it's because we discovered them.
When knowledge kills returns
The core problem is reflexivity. When academics discover a return pattern, they publish it. When practitioners read the research, they implement it. When everyone implements it, the pattern disappears.
Take the value premium: the historical tendency of cheap stocks (low P/E, low P/B) to outperform expensive ones. From 1927 to 2007, it delivered consistent excess returns. Then the research became widely known. Index funds launched. Quant strategies systematized it. Now? The value premium has delivered disappointing results for nearly two decades.
"The minute you productize a risk premium," Arnott explains, "you destroy its efficacy." The premium existed because human biases created inefficiencies. But once institutional capital floods in, those inefficiencies vanish. The behavioral edge becomes an efficient market outcome.
Why small-cap is broken
The small-cap premium tells a similar story. For decades, academic theory held that small companies outperform large ones because they're riskier. But Arnott points to a problem: when you exclude micro-caps (the smallest 1% of companies), the premium disappears entirely.
Here's why that matters: most institutional investors can't buy micro-caps. They're too illiquid, too expensive to trade, too risky from a fiduciary standpoint. So the "small-cap premium" that theoretically exists in academic studies isn't actually capturable in real portfolios at scale.
The truly small companies that drive the premium returns are off-limits to most investors. The small-caps that institutions can buy – think Russell 2000 companies – don't actually deliver reliable outperformance. The premium lives exactly where capital can't easily flow.
Where premiums still work
Arnott's research points to where risk premiums might still exist: places that are uncomfortable, illiquid, or socially unpopular. Emerging markets debt, for example, or distressed securities, or industries facing regulatory pressure.
The key insight: premiums survive where behavioral biases remain strong because structural or social barriers prevent capital from arbitraging them away. Investors won't touch tobacco stocks despite attractive valuations. They avoid frontier markets despite higher yields. They shun volatility strategies during calm periods despite positive carry.
These discomforts create the friction that allows premiums to persist. The moment they become "investable" to mainstream portfolios, the premium begins dying.
Implications for portfolio construction
For capital allocators, Arnott's work challenges fundamental assumptions. The 60/40 stock-bond portfolio was built on the idea that certain risk factors reliably deliver excess returns. If those factors have been arbitraged away, what's the new framework?
Arnott suggests focusing on three areas.
Truly illiquid opportunities where institutional capital can't compete, such as direct real estate, private credit, concentrated private equity positions.
Socially uncomfortable investments where behavioral biases create persistent mispricings.
Dynamic strategies that can adapt as premiums emerge and get arbitraged away.
The static factor portfolios that dominated the 2010s likely won't work in the 2020s. The premiums are gone. Smart money is moving on.
3. A framework for contrarian investing
InvestmentMarkets podcast, Episode: Contrarian Investing: Finding Value Where Others Don’t (Oct. 20, 2025)
TLDR:
True contrarian investing isn't just buying what's down. It's identifying temporary dislocations in quality assets caused by fear, misunderstanding, or forced selling.
The framework has three parts: (1) identify what the crowd believes, (2) find the flaw in that belief, (3) size positions based on your conviction vs consensus error magnitude
The key is distinguishing between "value traps" (cheap for good reasons) and "value opportunities" (cheap for temporary or irrational reasons)
Contrarian investing sounds simple: buy what everyone hates, sell what everyone loves. But most self-described contrarians just buy bad businesses at cheap prices and call themselves value investors. Real contrarian investing requires a more sophisticated framework.
The goal isn't to be different for the sake of being different. It's to identify situations where the crowd is wrong in a predictable way, and you can profit from their error.
The anatomy of crowd error
Markets make mistakes in predictable patterns. Understanding these patterns is the foundation of contrarian investing.
Recency bias: investors extrapolate recent trends too far into the future. When oil prices collapse, the market assumes they'll stay low forever. When tech stocks surge, the market believes growth will continue indefinitely.
Narrative fallacy: markets fall in love with stories and ignore facts that contradict them. The story becomes self-reinforcing until reality asserts itself. Think of the "death of retail" narrative during 2017-2019, when great retailers like TJX and Ross Stores traded at absurd discounts because everyone "knew" e-commerce would kill them.
Forced selling: when redemptions, margin calls, or regulatory requirements force investors to sell regardless of price, you get dislocations that have nothing to do with business fundamentals. The March 2020 COVID crash created these opportunities in municipal bonds, where cities had to sell at massive discounts despite no change in their ability to repay debt.
The three-step framework
Effective contrarian investing follows a disciplined process.
Step one: identify what the crowd believes. This requires reading analyst reports, listening to earnings calls, tracking positioning data, and understanding the dominant narrative. You can't profit from crowd error if you don't know what the crowd thinks.
Step two: find the flaw in the crowd's belief. This is the hard part. You need to identify why the market is wrong—not just hope it's wrong. Maybe they're extrapolating temporary factors. Maybe they're ignoring a catalyst. Maybe they're underestimating management's ability to adapt. The flaw must be specific and evidence-based, not just "I think it's too cheap."
Step three: size positions based on conviction and error magnitude. If the crowd is very wrong about something very important, you bet big. If the crowd is slightly wrong about something marginal, you bet small.
This is where most contrarians fail: they size positions based on how cheap something looks rather than how wrong the crowd is and how much it matters.
Value traps versus value opportunities
The biggest challenge in contrarian investing is distinguishing between assets that are cheap for good reasons (value traps) and assets that are cheap for temporary or irrational reasons (value opportunities).
Value traps share common characteristics: declining competitive positions, poor capital allocation, debt-heavy balance sheets, or fundamental business model challenges. These stocks can stay cheap forever because the earnings power continues eroding. Classic examples: traditional retailers losing to Amazon, or newspapers losing to digital media.
Value opportunities look different: strong competitive positions intact, temporary headwinds creating fear, forced selling driving prices below intrinsic value, or market misunderstanding of business model changes. These situations resolve as the temporary factor passes or the market corrects its misunderstanding.
The key question: is this cheap because it's dying, or cheap because everyone's temporarily scared?
Real examples in action
Consider energy stocks in 2020-2021. The crowd believed ESG concerns and the transition to renewables meant oil companies were "uninvestable." Major integrated oils traded at single-digit P/E ratios despite strong balance sheets and massive cash flow generation. The contrarian insight: even if oil demand peaks, it will decline slowly over decades, and current valuations implied oil would disappear tomorrow. Those who bought Exxon or Chevron at 2020 lows captured 100%+ returns as the market corrected its error.
Or consider Chinese tech stocks in 2021-2022 after regulatory crackdowns. The crowd believed Xi Jinping would destroy the sector. Everything traded at massive discounts. The contrarian view: China needs a thriving tech sector to compete globally, and after the initial crackdown, the government would find equilibrium. Companies like Alibaba and Tencent trading at 10-12x earnings with dominant market positions offered compelling risk-reward.
The Bottom Line
Contrarian investing isn't about being different. It's about being right when the crowd is wrong. That requires understanding what the crowd believes, identifying specific flaws in that belief, and sizing positions based on how wrong they are and how much it matters.
The best opportunities come when quality businesses face temporary headwinds that scare away capital but don't change long-term fundamentals.
Disclaimer
This newsletter is for informational and educational purposes only and should not be construed as personalized financial, tax, legal, or investment advice. The strategies and opinions discussed may not be suitable for your individual circumstances. Always consult a qualified financial advisor, tax professional, or attorney before making any decisions that could affect your finances. While we strive for accuracy, we make no representations or warranties about the completeness or reliability of the information provided. Past performance is not indicative of future results. All investments involve risk, including the possible loss of principal. The publisher, authors, and affiliated parties expressly disclaim any liability for actions taken or not taken based on the contents of this publication.
