Here's My Disaster Scenario For Stock Prices...
Hulton Archive/Getty ImagesToday's stock prices are so extreme that a drop of 40%-50% would not be a surprise.
Indeed, it would take a drop of this magnitude just to get back to average long-term valuation levels, let alone cheap.
Meanwhile, after 5 years of frantically pumping money into the financial system, the Fed is not only still going full bore (interest rates are zero) but facing ever-increasing pressure to ease off the gas.
So if stock prices do drop sharply, it doesn't seem likely that the Fed will be able to do much to help.
Meanwhile, corporate profit margins are still at all-time highs, wages are still at all-time lows, and average American consumers still have debt coming out of their ears.
So it seems likely that, at some point, profit margins will decline, wages will rise (we can only hope), and average American consumers will continue to rein in spending - none of which will boost further profit growth.
Meanwhile, interest rates are still at all-time lows. So if and when the economy does finally gather a sustainable head of steam, interest rates will likely rise. And rising interest rates don't tend to be helpful to stock prices.
So that's one scenario for stock prices over the next several years:
- Stock prices revert toward long-term averages
- The Fed eases off the gas
- Corporate profit margins revert toward their long-term averages (hopefully because companies finally start to share some of the wealth they create with the people who create it)
- Consumers continue to save money and work off debt
- Interest rates rise
If any of those things happen, stock performance will likely be poor for many years.
But that's not the disaster scenario. That actually seems like a perfectly reasonable scenario.
The disaster scenario is that some or all of these measures do not just revert toward their long-term averages but instead revert beyond their long-term averages - the way they almost always have before.
If we go from an era with spectacularly high stock prices, spectacularly low interest rates, spectacularly high profit margins, and spectacularly stimulative Fed policy to an era characterized by the opposite (like the 1970s), the sharp crashes and relatively quick recoveries of 2000 and 2008 will seem like brief, happy corrections.
It took about 25 years for the economy and market to correct the extremes of the 1920s. It took another 25 years to fully work off the (much lesser) extremes of the 1960s.
The extremes of the late 1990s, which have extended into the 2000s and, now, the 2010s, are, by some measures, the most extreme in history (including the 1920s).
It should not come as a surprise, therefore, if it takes us as long, if not longer, to work them off.
(Pictures are worth a thousand words, so please see the charts below...)
Stock prices are extraordinarily expensive. Today's cyclically-adjusted P/E ratio is the highest price-earnings ratio in 135 years, with the brief and temporary exceptions of 1929 and 2000. Interest rates, meanwhile (red line), are basically as low as they can go.
Robert Shiller
Corporate profit margins are at all-time highs, helping to support today's stock prices. Note how profit margins generally revert to (and beyond) the mean:
Business Insider, St. Louis FedAfter-tax profits as a percent of GDP.
The extremes of the 1920s and 1960s took decades to work off. The black line below shows the inflation-adjusted S&P 500 price for the past 130 years. Note the 25 years between the 1929 peak and the next sustained rise, as well as the 25 years after the 1960s peak. We're about 14 years into our current work-out period - from valuation extremes that were much higher than in the 1920s and 1960s. It wouldn't be surprising if we had another decade or more of work-out to go.
Robert Shiller
SEE ALSO: People Get Mad When I Say Stocks Might "Crash," So I Won't Use That Word, But...