Earlier this week I posted a commentary Is This Bull Market Fundamentally Driven? A Look at PE Expansion. The content was largely reprinted from an analysis at the Wall Street Rant website. Among the many email responses I received about the post, one in particular stood out. Jonathan Schoolar, a long-time veteran of the investment industry, wrote:
“Another, slightly less complicated way of looking at it is that bull markets go for as long as they go and for whatever reason. It is the terminal valuation that determines the degree of damage done in the subsequent bear market. Value must be reset, and the higher the starting point, the worse the decline when the bull driver ends.
Here is a quick look at the terminal Shiller P/E and subsequent declines using his info. Few data points but better “fit” than plotting the fundamental ratio. Bear markets from Shiller ratios above 20 are nasty.”
Jonathan’s email included a chart illustrating the cyclical P/Es at the peak before the 20% declines in the S&P 500 since its inception in March of 1957. Here is my annotated version of his chart. This is a scatter graph that uses the vertical axis to show the per cent declines of the nine bear markets over this timeframe. The horizontal axis shows the cycle P/E ratio at the peak preceding the decline.
Because this type of graph doesn’t show the chronology, I’ve used callouts to indicate the date of the trough (market low) following the peak. The regression is a linear “best fit” though the nine data points. Only four of the nine are tight fits to the regression. The three bear markets in the 1950s and ’60s were less severe. The savage decline linked to the surge inflationary surge following the Arab Oil Embargo in 1973 was an outlier to the downside, as was the bear market associated with the Great Recession — the one still vivid in our memories.
I highlighted the market trough in 1970 because the cyclical P/E ratio of its preceding peak in November of 1968 was 22.2. That’s the same as the latest ratio in February of this year.
As Jonathan points out, “bull markets go for as long as they go and for whatever reason.” As I type this, our current bull in the S&P 500 is just a few points, about half a per cent, from a new all-time high. Mainstream market mavens are increasingly bullish on US equities. For example, on Monday well-known analyst Meredith Whitney said: “I have not been this constructive and bullish on US equities in my career.” And of course we saw a cyclical P/E ratio north of 40 at the market peak in 2000.
At some point I hope to all another dot to the chart above. Where will it lie in the overall scatter? Only time will tell.
Appendix for Further Consideration
For a long-term look at the cyclical P/E 10 ratio, see my latest monthly update:
- Is the Stock Market Cheap?
Here is a chart of the S&P 500 with callouts for bear markets declines to one decimal place. I’ve also included a pair of near bears.
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