When I get quarterly announcements about how much my retirement account is currently worth, and a stock market crash has driven the total account down, I find myself looking at some long-term stock market price patterns.
To prepare the scene here is the historical pattern of the S&P stock index back in the 19th century. When interpreting the figure, note that the vertical axis is a logarithmic axis showing proportional changes; for example, tripling from 10 to 30 has the same size as tripling from 100 to 300 and the same as tripling from 1000 to 3000. a squiggle that would look like an almost flat line at the far left of the drawing.) You can see some of the well-known changes in the stock market over time: 1920s boom, 1929 crash, 1960s boom, relatively stable market 1970s, 1990s dot-com big jump, boom since 2009 and recent decline. Of course, whenever you consider the possibility that
For a slightly different look, hereThe same dataset, this time adjusted for inflation. Again, the vertical axis shows proportional change. Again, the main known changes are clearly visible, but not all of them look the same. For example, after adjusting for inflation, the Black Tuesday stock market crash in the 1920s is even more striking, while the real value of the S&P 500 falls during the high inflation period of the 1970s.
Of course, the value of the stock market should be influenced by corporate earnings expectations. In this way, The standard price-earnings measure in the stock market considers stock prices divided by corporate earnings for the previous 12 months.. Note that the logarithmic scales are now gone. Corporate earnings will grow in the long run, both due to inflation and along with the overall growth of the economy. Thus, the P/E ratio can be expected to be roughly the same over time, with some fluctuations of course as economic events and market trends interact. Indeed, when you look at the data for the stock market crash of 1929, it’s barely noticeable: after all, if both stock prices and corporate earnings fall at about the same time, then the ratio of the two may not change dramatically. path.
You can also see that from the late 19th century until around 1990, the P/E ratio did not have a long-term trend. It moved up and down, but was usually in the 15-20 range. However, since the 1990s, the P/E ratio has moved far beyond its historical range, first during the dot-com boom of the 1990s and then in the run-up to the Great Recession of 2008-2009. After the recent decline, the P/E ratio is now effectively back in its historical range.
However, the P/E ratio has at least one major drawback: if corporate earnings rise or fall sharply in a given year, perhaps for idiosyncratic reasons, then the denominator of the P/E ratio will jump. It can be useful to look at average corporate earnings over a period of more than 12 months to smooth out short-term fluctuations of this kind. So shThis is called the “cyclically adjusted price-to-earnings ratio, also known as the CAPE ratio or Schiller ratio, which divides the value of the S&P 500 index by the average earnings of firms included in this index, adjusted for inflation over the previous 10 years.. Here is the CAPE ratio:
Note that with this long-term adjustment, Black Tuesday 1929 becomes apparent again: in effect, the rise in stock prices in the 1920s and the fall in 1929 are now compared not only to modern earnings, but also to those of the previous 10 years. . Something similar happened during the Great Recession of 2008-2009: a sharp decline in earnings caused the unadjusted P/E ratio in the previous indicator to go through the roof, but if you average earnings over the previous decade, the CAPE ratio will not change. t show a similar peak. Again, there doesn’t seem to be a big long-term trend in stock market prices until around 1990, but then stock prices break through to historically high levels.
Recent price movements in the stock market look a little different in the context of the CAPE ratio. The jump in 2021 looks smaller than the usual P/E ratio, and the recent decline looks smaller too. The difference arises because corporate profits have risen rapidly over the past five years or so. This earnings growth tended to be held back by a simple vanilla P/E ratio through 2021 as the S&P 500 surged along with those earnings, but given long-term average earnings, stock market price increases through 2021 become more significant. evident. On a CAPE basis, stock prices are still at a high, though not unprecedented, level after their recent decline.
Will the stock market stay at this higher CAPE level? I’m definitely not a forecaster, and certainly not a short-term forecaster. But Without making predictions, Eric Zitzewitz summarizes some of the key issues in one of Econofact’s always helpful briefs. Web site:
There are reasons why a higher-than-usual CAPE might be appropriate in 2022. First, interest rates are below inflation, so the real interest rate (nominal rate minus inflation rate) is negative. This should increase the amount an investor must be willing to pay for $1 of current earnings, as earnings (and the dividends they fund) must rise with inflation, and the alternative of holding bonds rather than stocks is less attractive due to the still low face value. interest rates. Second, high price-to-earnings ratios in the United States partly reflect an industry sorting between the United States and Europe, where the United States has more fast-growth technology companies and Europe has more slow-growth consumer goods corporations. Third, CAPE is by design poorly responsive to recent income growth. Earnings have grown very fast over the past decade: after not growing at all per unit of the S&P 500 index between 2006 and 2016, they have almost doubled in 5 years, adjusted for inflation. When trying to predict future performance using past results, it is wise to give more weight to more recent results. CAPE does not; when comparing the value to the equal weighted average prior income, it implicitly uses the 10-year average as a forecast of future income. Estimates in 2021 look less like an outlier if we compare them to the previous year’s earnings, as in a simple P/E ratio.
Here is the last criterion known as the Buffett Ratio because Warren Buffett said back in 2001 in Fortune Journal interview that “this is probably the best single indicator of what the ratings are at any given moment.” It is the ratio of all publicly traded stocks (according to the Wilshire 5000 index) to the gross domestic product of the United States..
From 1970 to the present, the Buffett Ratio has averaged just under 90%: that is, the ratio of the value of all publicly traded shares to GDP has been just under 90%. When Buffett made his comment in 2001, you could have made money expecting the ratio to drop: you could have also made money on this advice up until the time before the Great Recession. But the spike in share prices since 2009 has seen share prices hit about 200% of GDP before a recent drop, and the value is still around 170% of GDP. As Zitzewitz points out, your confidence in this stock market value will depend on how long you think the recent growth in corporate earnings will be and how you view the “industry sorting” of fast-growing companies in the US. economy.
Of course, whenever you consider that the stock market may be behaving irrationally and that you might be able to make money betting that it will return to its “true” value, it is worth remembering the uncertainty associated with with such judgments, and in particular remember the old investment aphorism that “The market can stay irrational longer than you can stay solvent.”