As regular readers know, I’ve become increasingly worried about stock prices over the past 15 months.
I’m not predicting a crash, necessarily — my concern is based largely on valuation, and valuation unfortunately tells you nothing about what stocks will do next — but I certainly wouldn’t be surprised by one.
And you shouldn’t be, either.
For today, here are two charts that illustrate just how expensive stocks are.
First, professor Robert Shiller’s cyclically adjusted PE ratio. As you can see, according to this 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.
Second, here’s a look at a measure that has been described as Warren Buffett’s favourite stock-market indicator: market capitalisation to GDP. Specifically, this measure looks at the level of the Wilshire 5000, a broad stock index, to US gross domestic product. This measure is higher than at any time in history. Period.
Yes, when interest rates are low, the “fair value” of stocks is higher than it is when interest rates are higher. But that fair value is not as high as stock prices are today. Stock prices can also go down when interest rates are low (see Japan and the US in the Great Depression). And interest rates can change.
Yes, you can also quibble with both of these measures and others. The market index to GDP, for example, doesn’t take into account the increasing contribution of international operations to US companies’ revenue. The average Shiller P/E has been much higher in the past 30 years than it has been in all previous history, suggesting that something may have permanently changed.
But these are just quibbles. And even if you assume that historical relationships have permanently changed and that interest rates will stay low forever, you can’t easily conclude that today’s stock prices are “fair.” You can merely conclude (or at least hope) that stock prices can just keep going up.
And that’s certainly possible. Anything is possible.
But if the market should suddenly drop 30% to 50% or more, don’t act surprised. Because it won’t be a surprise. Every historically valid valuation measure out there suggests that that’s exactly what will happen.
The only question is, “when?”
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