Will The Stock Market Crash Now?

The Dow 1980-2013 (click image to enlarge)

You’ve probably heard: the stock market has been hitting new record highs lately.

It didn’t take long for the the boo birds to show up. “Just look! See how the market crashed each time it hit this level? It’s gonna happen again!”

Again, or Third Time’s the Charm?

It’s true: the peaks in 2001 and 2008 were roughly of equal height, and both were followed by devastating drops. It’s also true that the market has reached that level for a third time.

The glass half empty crowd hears the ominous music from Jaws, and says another crash is imminent. The glass half full crowd hears the music, too, and wonders: could history repeat itself?

Or dare they hope the third time’s the charm?

Can You Trust The Experts?

We like to say “no news is good news” (especially when our parents want to know why we don’t call or write). The media see it differently: they say good news is no news. No news —> no sales —> no pay. Bad news is what sells and pays the bills. You may disagree with their view, but you can’t really blame the media for loving bad news.

And that explains why the media love to quote experts, month after month, saying we’re about to fall into another recession. They said that all through 2012 but, as we know, the recession never came.

The doom prophets’ reasoning is simple: everyone knows another stock market crash is coming; it’s in the market’s DNA.

Nobody knows when, though.

You’re a smart investor, though, and you can see if they say every month, “Hey, it’s going to happen this month!” well, at some point there will have to come a month when they can’t help but be right.

As a smart investor you understand that of course, the media won’t ever mention their experts were wrong for 99 months, because who likes to tell others they carried predictions that didn’t come true? It doesn’t matter to them if the experts are right or wrong. All that matters to them is: are people reading those quotes? If readers are happy to read the same gloomy predictions month after month, who are they (the media) to deny us that pleasure?

Being a smart investor, therefore, you know we read and hear doom and gloom not because it’s truly imminent, but because human nature seems attracted to it, and it pays the media’s bills.

And so you’re not surprised to hear choruses of gloom every time the stock market reaches new heights.

Instead, you try to look at the numbers yourself and judge how imminent a crash really could be.

So, is a crash imminent?

I’m not a quotable expert (yet :)) but I say no, it doesn’t look like a crash is imminent, and here’s why not:

Valuation

Which do you think is a better deal: a used Yugo for $5,000 or a brand new Mercedes S-Class for $6,000?

Both are imports, both are fairly rare, and both are expensive to maintain. But the Yugo costs $1,000 less than the Mercedes, so it’s clearly the better deal. Right?

Can you see how it’s possible to “spin” together arguments which, while true in isolation, misrepresent the big picture? We all know a new Mercedes for only six grand offers way more value, despite the 20% premium. Those other arguments miss the point.

What point? The point of value. The Dow Jones (or S&P 500) index is the “price” of the market. The fact that the index at its highest point ever doesn’t by itself mean the market is overpriced, because it overlooks the key question: what does that price buy?

The value of a stock, or the market in general, is measured by something called the PE ratio. Without going into theory and heavy math, the higher the PE, the more you pay for what you get. Put another way, PE tells you how expensive a stock (or the market as a whole) is.

(Note: the issue of valuation is covered more thoroughly in the free Investing Basics series, available here.)

Let’s compare two companies we know well, Apple and Whole Foods, to see how it works. As of today, Apple’s stock is around $450 per share and Whole Foods’ is around $85. Apple looks a lot more expensive, doesn’t it?

But is it really? Let’s see. $450 (Apple) buys you profits of $44 per year, while $85 buys you an annual profit of $2.65 at Whole Foods. To compare apples with apples (no pun intended) $10,000 would buy us:

  • $970 in earnings per year with Apple
  • $300 in earnings per year with Whole Foods

Which would you rather have? Apple ($450) might look more expensive than Whole Foods ($85), but the value you get from Apple is more than three times as much. Like the Mercedes/Yugo example, what looks to be a high price might actually be the better deal.

Using the PE ratio:

  • Apple’s $450 buys you $44 in earnings, giving it a PE of just over 10.
  • Whole Foods’ $85 buys you $2.65 in earnings, giving it a PE of over 30.

The higher the PE number, the more expensive a stock truly is.

Valuing The Market

If you add up the earnings and the prices of all the companies on the stock exchanges, you arrive at the PE for the whole market.

If that number is low, we can say the market offers good value. But if the number is high, we can say the market is becoming more expensive. And the more expensive it is, the more susceptible it becomes to a crash.

So, is the market’s PE in danger territory yet?

PE history of the stock market, 1971-2013 (click image to enlarge)

The three most recent stock market crashes occurred in 2008, 2002 and 1992.

You can clearly see how the PE ratio for the stock market spiked before each crash.

You can also see that, at roughly 18, the market’s PE today is nowhere near a spike.

Therefore, although the market is at is highest point ever, it’s not because the PE is spiking like the previous two times. This time round, the rise in the Dow (and S&P 500) seems to be mainly because the total earnings of all the companies listed are at their highest point ever, too. 

There’s a good explanation for this: the recession forced companies to put the axe to their expenses (executives’ bonuses excepted, of course). As a result, the companies that make up the indexes are at their leanest ever, and any increase in sales yields a disproportionate gain in total profits, the E in PE. And the higher the earnings, the higher the price of individual stocks. Add up all the individual stocks and voila! The whole market rises, without an increase in the PE ratio.

Although the Mercedes is more expensive than the Yugo, it offers more value.

In the same way, it looks like the market today isn’t overpriced, even at its lofty level.

Back To The Future

So, is the stock market headed for a crash? It doesn’t seem likely, because there’s no spike in the PE ratio, the usual precursor to a crash. However, nothing is impossible, and there is always the chance that some extraneous event, like 9/11 or some civilized country reneging on its debt, can derail the market.

Many people have said the stock market’s high value is driven by the Fed’s Quantitative Easing program. If that were true, though, we would be seeing elevated PE levels. However, the chart shows us current PE levels are not that out of line with “ordinary times” in the past.

We could therefore expect that if corporate earnings keep going the way they’re going (up) the market should follow suit.

In fact, if there is a danger at this point, the danger might very well be that the soaring stock market will attract those investors who fled after getting burned by the crash of 2008. If that happens, it will push the market’s PE up, which in turn will attract more people into the market.

And, as we all know, that’s what people just love doing: buying high. :)

More about that sensitive topic next on Thursday.

 

5 Responses to Will The Stock Market Crash Now?

  1. My Money Design March 25, 2013 at 6:08 pm #

    I’m glad to see you brought up the PE ratio for the market because I was just thinking about that the minute I started reading this post. I think we’ve got a little while longer before we’re in the danger zone again. I’d expect interest rates to go up again for any real danger happens. And let’s hope so – if the market crashed with rates this low, there would be no QE tricks for the Fed to use to get us out of this predicament!

  2. William March 26, 2013 at 5:51 am #

    Thanks. I agree with your thought about interest rates going up. When that happens, we can probably expect some dramatic shifts in the financial landscape. I’m not sure anybody knows exactly what to expect, because the combination of dropping of interest rates to such historic lows, and the enormous debt binge the U.S. Government has been on has led to a bond bubble unlike any other. Here’s a link to an interesting article on the bond bubble:
    http://financialmentor.com/investment-advice/investment-strategy-alternative/bond-bubble

    So, when interest rates rise, the chase for yield could prompt investors to sell their bonds and rush into real estate and/or stocks. That could push the stock market up to more than double its current level in the next couple of years. Once a move like that gets under way, it will suck money from mattresses to push it even higher.

    Or, it could just easily lead to the opposite, because the wild card here is debt, and bonds are nothing but debt itself. Each and every bubble in the past (tulips to real estate to stocks) was funded with debt, and the popping of the bubble left people unable to repay the debt they incurred, and that failure to repay debt plunged entire nations into recession or depression.

    Is the current bond bubble funded with debt? Who would pay 8% interest to borrow money to invest in something yielding 2%? Someone who believed they could sell that bond in the future for more than they paid, to the tune of, say, 10% or 20% appreciation annualized. That, plus the little interest they receive on the bond, would encourage them to borrow to buy these bonds. If that’s happening, then the bond bubble bursting could turn very, very ugly in a hurry, and we could find ourselves in a huge recession with, as you pointed out, no ammunition to fix it.

    I can’t tell to what extent this is happening, but when interest rates turn north, and bond prices fall, we’ll quickly find out.

    Interesting times, but in a way nobody probably foresaw a year ago…

  3. Justin March 26, 2013 at 8:24 pm #

    As someone in their early 30’s who only has investments in retirement accounts, I wouldn’t mind a correction so I could pour more cheap money into it.
    Although any time the market gets too happy there are always bug-a-boos who want it to crash.

    • William March 26, 2013 at 9:15 pm #

      I hear you. The trick, of course, is to have cash when that happens. :)

  4. Brick By Brick Investing | Marvin March 27, 2013 at 1:35 pm #

    I believe the market will run higher than any of us can imagine due to the infinite amount of money printing and the low valuations we are seeing in the market. But only time will tell ūüėČ

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Again: Are We Close To A Stock Market Crash?

stock market crash guillebeau

If I give you the quick answer, I’ll just be one¬†of 287 talking heads… who don’t all agree. Instead, this (long) post will leave you with a tool so you can judge independently how close we are to the next stock market crash. So, grab a cup of something, and follow the chart-fest.

Do you fear a stock market crash¬†when you see it reaching its 30th record in 2014? Do you fear ¬†Does it make you at least nervous? Especially when you hear Nobel Prize winner Robert Shiller say “everything is pricey” and nations tremble in fear?

Well, this is Bite the Bullet Investing, where you learn how listen to facts, not fears or feelings.

Too many people have proclaimed for too long that the market is “too high” and disaster can strike imminently.¬†Problem is, while they were saying that, the market’s been doubling… and it hasn’t stopped! If you¬†listened to every expert/fearmonger proclaiming imminent disaster, you¬†would have missed out on one of the biggest bonanzas the stock market has given us.¬†Do you want to miss out like that? Didn’t think so.

On the one hand, you¬†know the market moves in cycles, and that a crash at some point is inevitable.¬†The key question, then, is not whether there will be a stock market crash or not — it’s when.

Let’s see if we can figure out what people are saying, beginning¬†with the quote above, and then moving on to¬†the debate surrounding it.

Most Experts’ Measure: The¬†PE

From the last few weeks you know the PE ratio of a stock measures how expensive it is, right? Well, you can add up all the prices and earnings of the stocks in an index, like the Dow Jones or S&P 500, and calculate the index’s¬†PE.¬†Then you can use that¬†to judge whether the stock market as a whole is overpriced. That’s what Prof. Shiller did, as quoted above.

But… there’s a twist. He doesn’t use the PE ratio like you and I would, he uses a “custom modified” version of it, which he calls the CAPE, for Cyclically Adjusted PE. (Can you guess why he didn’t go for the simpler “Adjusted PE?”) Any time anybody uses a custom APE ¬†(Adjusted PE), you wonder why. What’s wrong with Old Faithful, the plain-jane PE we use all the time?

Indeed, there are some people out there who caution against blindly accepting the CAPE as the last word in stock market valuation, including two outfits we pay attention to: AAII and the Motley Fool.

Here are two parties, both of whom I respect, disagreeing over an APE, created by a Nobel laureate. Could this be interesting?

Should this be interesting to you? Yes:

  • Using the CAPE, Prof. Shiller says the market is overvalued and ripe for a drop.
  • The plain old¬†PE, though, says the market’s really not overpriced at all.

Both can’t be true.¬†It’s your¬†money, so you need¬†to know¬†who’s right.

To find out, let’s compare the two PE measures.

Plain Old PE (POPE)

Prof. Shiller and Yale University are kind enough to offer free access to their database, which they keep updating. For that, all investors wanting to know what’s happening (and those who write about it) are grateful, because it’s truly an outstanding treasure trove¬†of data, going back to the late 1800’s.

Here’s a simple chart to¬†start: the plain old¬†PE ratio, with prices and earnings adjusted for inflation.

stock market crash 01

Chart 1: Conventional PE

You can see several things:

1. There is no “normal.”¬†The arithmetic average PE for the market is around 17-18, but the average itself keeps moving over time.¬†Remember, our goal is finding¬†something that will tell us¬†when stocks are¬†so overpriced that a stock market crash is imminent. The average PE ratio can’t¬†do that for us, because what’s the “normal” you will compare today’s value to?

You can’t use the 17-18 number, because the market’s been above that for more than ten years, and the market hasn’t been in a constant crash.

2. The PE moves in trends:¬†In¬†1960-1980, the market’s PE went down, then it started rising:

stock market crash 02

Chart 2: PE’s changing trends

What caused that change?

3. Interest rates. Those who did the free Investing Basics series will recall bonds dominate all investing. Interest rates set bond prices, which in turn impact stock prices.

If you had any doubts, check this chart:

stock market crash 04c

Chart 3: Interest rates affecting the S&P 500 PE ratio

As interest rates rose before 1980, the stock market’s PE dropped. Then, when interest rates started dropping, the stock market PE went up, especially the peaks.

That’s no coincidence.

4. Bottom line: take a look at the orange line in any of the charts above.

Where is it today? Is it in the stratosphere, or on a rocket launch toward it?

No…¬†It’s less than 20, not¬†far from the “new normal” of the low-interest rate new millennium.

Now let’s look at how the other side sees it.

Cyclically Adjusted PE (CAPE)

What’s the difference between the CAPE and POPE?

Everyone understands a¬†PE ratio. (Those who don’t, can refer to¬†this post¬†of a few weeks earlier.) The CAPE ratio is, as its name implies, a variation of the PE ratio we use every day. A good¬†way to understand the difference is seeing¬†the two calculations side by side:

CAPE comparison

You can see the difference is how many years’ earnings (the E in PE) are used. The POPE uses the last 4 quarters, also known as trailing twelve months, or ttm, while the CAPE uses the previous ten years.

Why use the CAPE? Its creator, Prof. Shiller, did it¬†in order to smooth out¬†past performance. People use¬†a moving average (for any number), to smooth out wild swings in the number they’re trying to gauge. It gives you a better visual¬†for trends which you might miss when you see gyrations in the number itself.

The number needing smoothing is the E in P/E:¬†the earnings.¬†Here’s a chart that compares the smoothed earnings for the CAPE¬†with its wild natural counterpart:

Stock market crash 05

Chart 4: S&P 500 Earnings, real and smoothed

You notice:

1. Smoothing clearly works… if ironing out the peaks and valleys is your goal, but that’s not nearly as interesting to you¬†as the next one:

2. Earnings are steadily increasing as the capital engine of America cranks out more and more profits. (Remember, these numbers are adjusted for inflation, so this is real growth you’re looking at.)

3. Earnings have fluctuated more since the new millennium.

Okay, we saw what the conventional POPE looks like on a chart. So, what does the CAPE look like?

stock market crash 06

Chart 5: CAPE since 1980

Does this chart tell you anything Chart #1 doesn’t? It actually looks like the stock market is becoming cheaper after the 2000 peak.

In particular, I see no “normal” here.¬†Why do I care about “normal?” Because everyone using¬†the CAPE says it’s too high in 2014 because it’s higher “than normal.” What normal? Clearly low interest rates have elevated normal, so you can’t compare it with the days of high interest rates.

They go further:¬†disaster is imminent because the CAPE is higher than normal. ¬†Well, if that’s the criterion, then the market should have been crashing every day since 1996¬†because the market’s been above the historic normal all the time. That didn’t happen.

Clearly, the CAPE is no improvement on the Plain Old PE when it comes to signaling an impending stock market crash.

Let’s compare the two side by side.

(If your eyes are glazing over, hold on. Grab a refill. This is about to get very interesting.)

Comparison

It gets all complicated when you have too many lines, so let’s plot¬†the S&P against the CAPE and POPE in separate charts.

The turning points, when each stock market crash began, is marked with a red dotted line. (The S&P index has been adjusted for inflation, in case you thought it never reached 2,000 in 2001.)

stock market crash 08b

Chart 8: Comparing the turning points

The two lines match very closely, don’t they? My hunch is it’s this correlation that has so many people feeling¬†the CAPE is the perfect indicator of the stock market being¬†overvalued.

Only one problem: the teal line (CAPE) moves so closely with the S&P index line, what’s the point? It doesn’t tell us anything the blue line doesn’t. Most importantly, it¬†doesn’t turn down before the blue line. That makes it useless for investors.

Fast forward to today. Use the right limits of the charts and tell me: are we close to the next stock market crash? You can’t. Both appear “high,” but both appeared high in 2012, too. And did the market crash in 2012? Or 2013? No.

The current¬†thesis by “the experts” is that the CAPE is the best measure of whether the market is overvalued or not. Therefore, it offers a heads-up as to when the next stock market crash will happen.

It doesn’t look all that good; let’s see if it’s any better than the plain old PE (POPE):

stock market crash 09b

Chart 9: The S&P 500 and the POPE

Neither CAPE nor POPE signaled the first two downturns. The POPE clearly signaled the 2001 stock market crash, but it totally missed the 2008 crash, while the CAPE missed them both.

Comparing the two, the CAPE has no advantage over the POPE, but neither warm the cockles of our investing hearts.

As I did the research for this post, I sat back at this point, because I sincerely hoped at least one of the two measures would give us something to hang our investing hats on.

Deep sigh.

Is There Something We’re Missing?

Remember the movie¬†My Cousin Vinnie,¬†where Vinnie stared at the key piece of evidence without realizing it? He knew he was missing something, but he just couldn’t put his finger on it. It was only after looking at it for a while that it hit him, and he went on to thrillingly win his first case. (I love that movie, in case you haven’t figured that out by now.)

I can’t help feeling there’s something missing that we all are¬†overlooking.

So I pored over the charts above and the two hundred others I drew which ended up on the cutting room floor. Look back at those huge spikes in the S&P 500 PE (plain old) in chart #1 above.

What caused those spikes? Your first guess would be the ridiculous prices of the time, right?

Or could it be the earnings? Remember this formula comparison from above:

CAPE comparison

The Formula, Revisited

Regardless of which PE measure you use, the formula always has two components, prince and earnings. That means the PE can spike when prices zoom OR when earnings plunge.

Hmmm… let’s look at that a little more:

stock market crash 12

Chart 10: Earnings as determinant of Price in the S&P 500 index

Wow! Will you look at that? Look how clearly you can see most of the spikes and dips in the PE ratio coming from dips and spikes in the 500 companies’ earnings. Look at 1992. See how, when earnings dropped, it caused the PE to spike as the index didn’t immediately react to the declining earnings? Same with 2001-02. And the most dramatic PE spike, which most people associate with the crazy prices before the previous stock market crash in 2008, came NOT from crazy prices, but from earnings falling off a cliff.

And, most important of all, the earnings drop came BEFORE the big crash!

Could this be something?

Let’s plot¬†those earnings against the S&P 500 and see. (Note” TTM stands for trailing twelve months, i.e. the last 4 reported quarters.)

stock market crash 14

Chart 11: S&P 500 against the previous 12 months’ earnings (TTM Earnings)

The dotted green ovals show how earnings began to drop before the subsequent stock market crash:

  • The 1987 crash was preceded by two years of declining earnings. A¬†fair warning, if ever you needed one, right? Let’s¬†give it an A.
  • The 1991 crash was preceded by one¬†years’ worth of declining earnings. Not bad, either, let’s say a B
  • The 2001 crash was preceded by declining earnings, but then earnings¬†picked back up and peaked at the same time. That one, not so good: if you followed that lead, you would have lost out all the gains of that cycle. So, that’s¬†an F.
  • The 2008 warning was short, but steep. I’d still give it a C grade.

Not perfect, to be sure, but a whole lot better as a predictor of the next stock market crash than either of the two PE numbers.

I think we’re on to something here. Here’s something else I saw. Let’s¬†look at earnings and nothing else. Perhaps there’s something else that can help us.

stock market crash 15

Chart 12: Earnings of the S&P 500 companies

Step back and consider what you’re looking at. This isn’t just a chart. It isn’t even the stock market. You’re looking at all the profits generated in America! Well, almost all, because the 500 largest public corporations earn the lion’s share of all the profits in the country, if not the world.

When I look at the chart, the dotted green arrow shows how profits have been growing, which is not all that surprising. (The dotted red lines show when the stock market crashed each time, just like before.)

If charts could tell a story, here’s what this one could tell us: As mighty as America’s economy is, it can only produce so much profit before it overreaches, and collapses to recover. Then it starts over again, making more and more profits (earnings) until it again reaches an unsustainable peak, at which time it collapses again, and the whole cycle starts all over again. Because the economy is growing and we get better at what we do, each peak is higher than the one before.

Once we understand this, the chart gives us a tool we’ve never had before: Although nothing is precise, it would seem that whenever the orange line approaches the green dotted line, the economy reaches the limits of what it can generate, overshoots, and collapses.

The Answer

We started out asking: are we close to the next stock market crash?

The answer is: yes. But it looks like there are still some more earnings to be extracted from this economic cycle before the market runs out of gas, as it were, and exhales.

While the answer may be the same as those using the CAPE, this view offers you a more clearly discernible predictor than either of the PE models. And it certainly beats the fearmongers who simply say if the market’s high (however high “high” is) it will crash and burn.

Personally, I’m looking for the earnings number, as defined and tracked by Prof. Shiller, to get closer to 110 before I open the envelope and unfold my disaster plan. If you want to do the same, this is the link. It will get you an Excel spreadsheet called ie_data. Open it, and you’ll find three tabs, with one called “data” at the end, like this:

stock market crash 16

Click on the Data tab and open the full window. You’ll see many columns of data. The second to last column is the one you’re interested in:

stock market crash 17

Now, scroll that baby down to the end. This is how it looked as of August, 2014. You can see they wait till all the quarterly numbers come in. Then they insert that and interpolate the intervening two months’ data to provide a continuous line.

stock market crash 18

I don’t know when they will update their database.

In the meantime, though, I do a quick-and-dirty view, by glancing at the SPY PE ratio, and dividing the PE which I see into the S&P reading of the day. So, when the S&P hit 2000, the SPY PE showed 17.

2000 √∑ 17 = almost 118, right about where the green arrowhead rests.

Finally, a reminder: we’re talking about the future, that thing nobody knows. Least of all you and I. I’m not pretending for a second this measure is a guaranteed predictor of the next stock market crash. But neither are the measures other people use. The problem with the PE-based measures is what stats people call false positives, i.e. it says there will be a drop and it never happens. The last chart shows every peak, and the majority of them precede drops in the market. Although it looks like a better tool, it can’t be perfect. Nothing is.

So… what do you think? More importantly, what do you base that on?

 

 

image: chris guillebeau

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