Throughout history, there have been repeated stock market crashes. It happens quite frequently, in fact. Since the credit super-cycle started in the United States in the early 1980’s, there have been three: 1987, 2001-2003, 2008-2009 (and four if you add the 1994 bond market massacre to the list). But why does this happen? And is there any way to figure out if it might happen again?
If you listen to the lunatics at the Federal Reserve, there is no way to recognize a bubble until after the fact and there is no discernable cause of bubbles. Of course that is convenient for them to say, because they are the ones that cause asset price distortions through the manipulation of interest rates. Recognizing the cause of bubbles would require the Pharisees at the Fed to look in the mirror, which they are clearly incapable of doing.
For the purposes of this article, however, the causes of stock market bubbles isn’t important; that is a topic for a different time. For now, the important question is this: is there a stock market bubble today? Is there any way to analyze data points to come to a conclusion about the risk of yet another stock market crash? Is there something that the clueless economic clergy at the Fed is missing? Yes, yes, and yes.
Stock investing is really simple: buy low, sell high. It is common sense that the less you pay for stocks, the higher your potential returns over time, and the lower the risk of losses. The opposite is also true: if you pay a high price, your return potential is low, and your risk is high. That is simple enough, right? It is just a matter of determining if stock prices are high or low.
The simplest pricing metric for stocks is the price-to-earnings (P/E) ratio. How much are you paying for corporate earnings? Very simply, the lower the number, the cheaper the stock. A nice round number for a reasonable P/E ratio is 10. If a company makes $1 million per year, then you would be paying $10 million to buy that company. There are many other pricing metrics beyond the P/E ratio like price-to-revenue, price-to-book value, and many others. But which one is the best?
A good place to start is with Robert Shiller of Yale University, who because famous for predicting the real estate crash using a unique pricing mechanism. He also created something called the CAPE Ratio for the stock market, which stands for cyclically adjusted price-to-earnings ratio. The idea is that there are cycles in earnings, so the best way to determine the long-term earnings capability of a company, you have to average the last ten years of earnings. The historical average Cape ratio is 16.7. It is currently at 26.6, or about 60% higher than average. In other words, the market has to crash by 40% just to get back to the average cyclically adjusted price-to-earnings ratio. Not good.
Another great way to gauge the price of stocks is called the “Buffet Indicator”, named after the legendary investor Warren Buffett. The indicator is the total value of all stocks divided by GDP. It makes a lot of sense; stock prices are determined by earnings, which are determined by the size of the economy. Therefore, you don’t want to pay too much for stock in relation to GDP. The historical average of the Buffett indicator is 69.7%. It is now at about 120%, which means that the market would have to crash by 58% to get back to average. Even worse.
While the Cape Ratio and Buffett Indicator are two great ways to recognize stock market bubbles, there is a much more holistic approach provided by Dr. John Hussman. In my opinion, he is the foremost expert in equity valuations and future return assumptions. He looks at indicators similar to the Cape Ratio and Buffett Indicator, but goes further and includes a wide array of other metrics to factor in, and provides return assumptions for a 10-12 year timeframe. (If you are interesting in this topic, I highly recommend reading his weekly updates at Hussmanfunds.com).
One major thing to factor in, according to Hussman, is the cyclical nature of profit margins. Profit margins go up and down based on a variety of factors, but revert back to the mean for obvious reasons, like competition.
The current stock market bubble is a double whammy. Valuations are historically high by every measure, and profit margins are also at a cyclical high. When profit margins and valuations both revert back to the mean, we are in for a serious stock market crash. Hussman’s conclusion: this stock market bubble will result in a 40%-55% crash, and that is just the run-of-the-mill outcome. It could be far worse.
There is a stock market bubble, no doubt. The level of mania in the US stock market is out of control. Stock prices have left reality and never looked back (apart from a couple peeks at reality in August 2015 and then again in Jan/Feb of 2016.) Valuations are totally out of touch with the economy. Investors ignore time tested valuation metrics while declaring that “this time is different”.
This time will not be different. This stock market will eventually crash; it is not a matter of if, it is a matter of when.
And it is quite clear when it will happen: the stock market will crash when the next recession/debt crisis strikes. Of course, it is anybody’s guess when the next recession hits. My guess is probably in 2017, but by the end of 2018 at the latest.
Are you prepared?