Is the market going to crash? Let’s look at two bodies of evidence based on the Shiller PE Ratio that points in the exact opposite direction
The year before the crash is always a great year for the stock market. The S&P 500 grew by 9.5% in 2016. It was the 8th year after the 2008 recession yet the U.S. stock market continued to rally. Every year since 2011 people have been crying about the coming of another stock market crash; had they listened to their advice they would’ve missed out. While we know that the stock market goes up and down according to business cycles, and business cycles crash every 7 to 12 years, we don’t know if 2017, 2018, or 2019 will be the year of the crash or another year for the rush.
Is the market going to crash? Yes!
No indicator predicts whether the market is going to crash. But the closest one is the S&P 500 Shiller PE Ratio. This ratio is different from a normal price-to-earnings ratio in that it (1) uses the annual earnings over the past ten years, and it (2) adjusts for inflation. It makes the Shiller PE Ratio less volatile.
We see in the chart below the Shiller PE Ratio from 1880 to 2017, courtesy of www.multpl.com. The Shiller PE Ratio is 28.13 as of MLK day (1/16), 2017. The last time the Shiller PE Ratio was above 27 was October 2007, the beginning of the recent financial recession. The higher the PE ratio, the more “expensive” the stock is. $28 is such a high PE ratio that it had only occurred three times in history: (1) in 1928 at the start of the Great Depression, (2) in the late 1990s before the dot-com tech bubble, and (3) in 2007 before the global finance crisis. Doesn’t this sound like a sure sign of doom to come?
Is the market going to crash? No!
But savvy investors also point out that the Shiller PE Ratio in 1996 was also above 28. The stock market between 1996 to 1999 had skyrocketed before it went crashing down. So had you stopped investing the moment the PE ratio hit above $28, you would’ve missed out on one of the sharpest bull runs in history. Plus, the world is very different today than it was 25 years ago. We’re in the Information Age, where companies can be unprofitable for years (like Amazon) while they build up the “intangible assets” and “ecosystems.” Amazon has not made money since its birth, but Amazon’s stock, had people purchased in since the beginning, would’ve turned many into millionaires.
Shiller PE Ratio points in the exact opposite direction. What to do about it?
If you are less than 60 years old, keep saving! The market will rise and correct itself. But attempting to time the correction is just a gamble. If you need some short-term thrill, head to Vegas instead. People who are far from retirement (below 60 years of age) are going to be fine. The world has gotten so much better than it was 50 years ago, and despite our short-term shenanigans, it will continue to get even better in the future. Keep investing, keep saving, keep diversifying, and keep creating.