A 40% drop?

Barron’s magazine published an article in this week’s issue : A Skeptic’s View of the Trump Rally – Dreyfus Global Real Return manager sees stocks falling 40% or more once long-term trends reassert themselvesThe article expresses the view of fund manager Suzanne Hutchins. I agree with her, although I don’t necessarily see such a drop in stock prices as imminent.

The number 40% reminds me of a simple calculation I performed in my mind recently. The Shiller PE ratio (inverse of the earning yield) of the US stock market reverts to its mean in the “long-term”. The long-term mean for the Shiller PE ratio is 16.7. Right now, the Shiller PE is at ~28. A return to historical mean would imply a drop of (28-16.7)/28 = 40.4%. That’s pretty close to the 40% number in the article.

shiller-pe-87cab6b279fa9ea8

There are many other considerations though.

First, in the language of statistics, the distribution of the Shiller PE ratio isn’t stationary. It demonstrates trends lasting decades. Its mean is strongly influenced by interest rates among other factors. In a low interest rate regime, considerations of opportunity cost would induce the Shiller PE to remain higher (stocks would maintain a lower earning yield) than its long-term mean. This has happened in recent decades thanks to an extended low interest rate environment. So, one could question the premise that the Shiller PE would return to its long-term mean. It isn’t hard to see from the chart above that recent decades have supported average Shiller PE values above 20. A drop from 28 to 20 is a big drop, but closer to 30% instead of 40%.

Second, when the market crashes, it doesn’t crash to the mean of historic patterns, it usually overshoots, i.e.,  crashes further down, so a large crash can be expected.

Third, major market crashes begin in anticipation of recessions, and the market hits bottom often when the recession in underway. In a recession, earnings are lower than in boom time e.g. today. Doing the math, if the PE ratio were to go down to its historic mean of 16.7 during a recession when earnings were, say 25% lower than they are now, then we would see a market drop of 55% from present levels.

Finally, and worth repeating: while I see such a drop as probable, I don’t necessarily see it as imminent. In the last two major market crashes 1. post the dot-com bubble, and 2. post the housing bubble, the market crashes were predicted and anticipated by many, but the decline did not start until long after people started predicting it. Signs of economic stress were felt for years even though the market did not crash. The St. Louis Fed publishes a Financial Stress Index, which is a composite of several indicators of economic stress (below).

fredgraph

Looking at the chart above tells us that stress levels were above zero since 1994 even though the market, driven by euphoria, went to bizarre highs all the way to the end of the 1990s. And post the housing bubble, although stress started to spike up in late 2007, the big crash only happened in late 2008. Right now, the stress index reads negative (i.e. low stress), and not just barely negative but its value is easily in the bottom quartile of values since 1994. The economy is doing fine. That’s one reason why I don’t see a crash as imminent.

Of course, there’s always the risk of unforeseen events (e.g. natural or manmade catastrophes) or harebrained policy actions triggering market collapses prematurely.

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