Sorry, But It's Time To Remind You About The Possibility Of A Stock Market Crash

Henry BlodgetJun 30, 2014, 17:15 IST

Price: Stocks are very expensive

In the past year or two, stocks have moved from being "expensive" to "very expensive." In fact, according to one historically valid measure, stocks are now more expensive than they have been at any time in the past 130 years with the exception of 1929 and 2000 (and we know what happened in those years).

The chart below is from Yale professor Robert Shiller. It shows the cyclically adjusted price-earnings ratio of the S&P 500 for the last 130 years. As you can see, today's PE ratio of 26X is miles above the long-term average of 15X. In fact, it's higher than at any point in the 20th century with the exception of the months that preceded the two biggest stock-market crashes in history.

Robert Shiller

Does a high PE mean the market is going to crash? No. Sometimes, as in 2000, the PE just keeps getting higher. For a while. But, eventually, gravity takes hold. And in the past, without exception, a PE as high as today's has foreshadowed lousy returns for the next 7-10 years.

While we're at it, please note something else in the chart above. Please note that, sometimes-as in the entire first 70 years of the last century-PEs (blue line) can be low even when interest rates (red line) are low. That's worth noting because, today, you often hear bulls say that today's high PEs are totally justified by today's low interest rates. Even if this were true-even if history did not clearly show that you can have low PEs with low rates-this argument would not protect you from future losses, because today's low rates could eventually regress upwards to normal. But it's also just not true that low rates always mean high PEs.

And in case some of your bullish friends have convinced you that Professor Shiller's P/E analysis is otherwise flawed, check out the chart below. It's from fund manager John Hussman. It shows six valuation measures in addition to the Shiller PE that have been highly predictive of future returns. The left scale shows the predicted 10-year return for stocks according to each valuation measure. The colored lines (except green) show the predicted return for each measure at any given time. The green line is the actual return over the 10 years from that point (it ends 10 years ago). Today, the average expected return for the next 10 years is slightly positive - just under 2% a year. That's not horrible. But it's a far cry from the 10% long-term average.

John Hussman, Hussman Funds

And, lastly, lest you're tempted to dismiss both Shiller and Hussman as party-pooping idiots, here's one more chart. This one's from James Montier at GMO. Montier, one of Wall Street's smartest strategists, is also very concerned about today's valuations. He does not think it's "different this time."

Montier's chart shows that another of the common arguments used to debunk Professor Shiller's PE chart is bogus. Bulls often say that Professor Shiller's PE is flawed because it includes the crappy earnings year during the financial crisis. Montier shows that this criticism is misplaced. Even when you include 2009 earnings (purple), Montier observes, 10-year average corporate earnings (blue) are well above trend (orange). This suggests that, far from overstating how expensive stocks are, Prof. Shiller's chart might be understating it.

Jamies Montier, GMO

In short, Montier thinks that all the arguments you hear about why today's stock prices are actually cheap are just the same kinds of bogus arguments you always hear in the years leading up to market peaks: Seemingly sophisticated attempts to justify more buying by those who have a vested interest in more buying.

So, by all means, go ahead and tell yourself that stocks aren't expensive. But be aware of what you're likely doing. What you're likely doing is what others who persuaded themselves to buy stocks near previous market peaks (as I did in 2000) were doing: Saying, "it's different this time."

That's price. Next comes profit margins.

Today's profit margins are extremely, abnormally high

One reason many investors think stocks are reasonably priced is that they are comparing today's stock prices to this year's earnings and next year's expected earnings. In some years, when profit margins are normal, this valuation measure is meaningful. In other years, however - at the peak or trough of the business cycle - comparing prices to one year's earnings can produce a very misleading sense of value.

Profit margins tend to be "mean-reverting," meaning that they go through periods of being above or below average but eventually-sometimes violently-regress toward the mean. As a result, it is dangerous to conclude that one year of earnings is a fair measure of long-term "earning power." If you look at a year of high earnings and conclude these high earnings will go on forever, for example, you can get clobbered.

(It works the other way, too. In years with depressed earnings, stocks can look artificially expensive. That's one reason a lot of investors missed the buying opportunity during the financial crisis. Measured on 2009's clobbered earnings, stocks looked expensive. But they weren't. They were actually undervalued.)

Have a glance at this recent chart of profits as a percent of the economy. Today's profit margins are the highest in history, by a mile. Note that, in every previous instance in which profit margins have reached extreme levels like today's - high and low - they have subsequently reverted to (or beyond) the mean. And when profit margins have reverted, so have stock prices.

Business Insider, St. Louis FedAfter-tax profits as a percent of GDP.

Now, again, you can tell yourself stories about why, this time, profit margins have reached a "permanently high plateau," as a famous economist remarked about stock prices just before the crash in 1929. And, unlike that economist, you might be right. But as you are telling yourself these stories, please recognize that what you are really saying is "It's different this time." And "it's different this time" are described as "the four most expensive words in the English language."

And then there's Fed tightening...

For the last five years, the Fed has been frantically pumping more and more money into Wall Street, keeping interest rates low to encourage hedge funds and other investors to borrow and speculate. This free money, and the resulting speculation, has helped drive stocks to their current very expensive levels.

But now the Fed is starting to "take away the punch bowl," as Wall Street is fond of saying.

Specifically, the Fed is beginning to reduce the amount of money that it is pumping into Wall Street.

To be sure, for now, the Fed is still pumping oceans of money into Wall Street. But, in the past, it has been the change in direction of Fed money-pumping that has been important to the stock market, not the absolute level.

In the past, major changes in direction of Fed money-pumping have often been followed by changes in direction of stock prices. Not immediately. And not always. But often.

Let's go to the history ...

Here's a look at the last 50 years. The blue line is the Fed Funds rate (a proxy for the level of Fed money-pumping.) The red line is the S&P 500. We'll zoom in on specific periods in a moment. But just note that Fed policy goes through "tightening" and "easing" phases, just as stocks go through bull and bear markets. And sometimes these phases are correlated.