The potential for the stock market to collapse seems to be on everyone’s lips these days. Not a day goes by that I don’t see an article on a major financial news site about the impending stock market collapse. Some even ask are we in a “Stock Market Bubble?”
Age of the Bull and a Stock Market Bubble
Much talk of the current state of the market starts with how long the market has been raising. Articles like this is the 9th straight year of market increases, and the longest increase since (name that crash). So, the first thing we can get out of the way is, there is no age limit on market moves. Whether the current market movement is up, down, left, right, or horizontal, the fact that it’s been 9 years since the last recession has no bearing on what the market will do next. Even if it did, the argument misses that while year on year growth has continued over the 9-year period, several shorter corrections have occurred during this period. How long should the correction be to reset the imaginary clock on a bull lasting too long? Does it need to be a full-scale recession or is 3 months enough? So, let us dismiss the aged bull argument out of hand and ask the more important questions.
The two most compelling arguments I’ve heard that a stock market bubble is currently in effect are that investors are way too positive on the market and that valuations are too high for earnings. We can examine these one at a time.
Investor Sentiment and a Stock Market Bubble
The first is whether investors are way too positive on the market. On the one hand, I agree in some respects. Look purely at how many people are now touting being 100% stocks. The number is at quite a high. Another indicator might be the number of personal finance bloggers appearing on the scene, especially those specializing in early retirement. A common refrain about past stock market bubbles has been that when even the paper boy is giving you opinions on stocks it’s time to get out of the market. We may be approaching that point.
However, there is a contrarian point as well. How many articles like this one are simply questions of if there is a bubble or is a crash coming? Admittedly most of them have much less substance. Still the media itself is not currently unabashedly positive on the market, and yet their voiced concerns about the market have not led to a crash. I.E. maybe investor sentiment is not as positive as what would appear from ancillary evidence. Now I would be remiss from mentioning that per Robert Shiller in “Irrational Exuberance 3rd edition” the media often precipitates the moves of the market, but reaction lags news by some time period. As such it is possible the crash is coming and the media’s concerns have kicked off a cascade of a crash we will see in a few weeks or months now that people are paying attention.
So, what about valuation?
Company earnings are growing again after a period of stagnation in 2016. The problem is the price of the market is growing faster than earnings. The S&P500 has gained over 20% in the last year. That is way more than earnings increases, and more this year to date than most forecasters predicted for the entire year!
Not only is the growth of price outstripping earnings, but existing valuations are already high. Shiller’s own CAPE Ratio, which measures the price per equity (P/E) over the last 10 years, is currently at 27 compared to a normal 16. Even normal P/E is 25 compared to a historical average of somewhere between 15-16 depending on your starting point. Even if you consider only the last 25 years, assuming they are somehow unique due to the internet the average is only 19. So, by any measure the market is overvalued and prices are rising faster than earnings.
Does this Mean the Market Will Crash?
Most certainly the market will crash….. but when is a major question. The current market position is both overvalued and has an abundance of bullish behavior. But it is by no means the highest it has ever been for an up market. Pre-price bubble pop in 1999 the P/E ratio was over 30. CAPE P/E in 1999 was 44. Obviously, this is significantly higher than a CAPE P/E of 27 and a P/E of 25. Furthermore, if we go back to the Stock Market Bubble of the dot com era we see irrationally bullish movement for years before the collapse. Allen Greenspan gave his famous “Irrational Exuberance” speech in 1996. The CAPE P/E at that time was at 25. It took another 3 years for the market to fall. That’s three years of dividends and increasing stock market returns. So needless to say, the fact that the market is overvalued does not mean a crash is coming any time soon.
So why did I say “Most certainly the market will crash”? Simply put, crashes happen. The market itself is defined by a tendency to go up in the long run with periods of significant downward medium term movement. High P/E or low, a crash will occur at some point in the future, it is an inevitability. However, since we can’t show when that crash is going to occur we must instead stay the course lest we miss out on the interim gains. The best course of action is to ignore market news and just continue to stick to our plans.
Do you believe a crash is coming? When? Why?
This post has an Affiliate Link to Shiller’s book. Should you choose to purchase through this link I will receive some renumeration through no cost to you. I enjoyed this book.