Sorry to Spoil the Party, but Who’s Ready for a Stock-Market Crash?

It’s common knowledge on Wall Street that the Federal Reserve’s monetary policy has eliminated all investing risks by propping up stocks since the low in March 2009.

This is my view: “I understand this point of view, but I strongly disagree with its underlying premise.”

Frankly, I wonder whether any amount of arm-waving will cause the average investor to examine his risk exposures, much less consider the prospect of a 40 percent-plus decline in the S&P 500 that would only serve to bring stocks back to historical valuation levels. The benchmark index yesterday rose to a record, bringing the gain so far this year to 23 percent.

But I get it. This time is different. The all-powerful Fed will not allow stocks to go lower. That’s why nobody cares.

That’s because, as financial writer Brandon Smith, says:

“Human beings desperately want to belong, but they also desperately want to understand the environment around them. Often the desire to belong and the desire to know the truth conflict. The idea of the majority view, or the ‘mainstream,’ gives people the sense that they are a part of a group, and at the same time, gives them the illusion of being informed.”

Stocks are currently overvalued because investor sentiment is overwhelmingly positive and the Federal Reserve’s monetary policies are so accommodating.

As an example, a couple of days ago I heard a well-known institutional Wall Street investor say stocks are “underowned” —  as if every share of stock presently in existence is not actually owned by someone. To assert that stocks can be “underowned” reflects either a misunderstanding of how markets work, or signals an intention to pass off overvalued institutional equity holdings to everyday investors.

All of this explains why the bears are gone, extinct, vanished. Among the ones remaining, many are people whom I would consider to be either perma-bears or nut cases. And, yet, the historical evidence for a major market drop has rarely been stronger.

Virtually every reliable measure of stock-market valuation is now within the highest 1 percent of historical observations prior to the late-1990s bubble. “Reliable,” in this context, refers to valuation measures that are well-correlated with actual subsequent market returns. Those measures include price-to-revenue, price-to-book, various cyclically adjusted price-to-earnings multiples, and market values-to-GDP, among others.

As evidence, consider this: At the market’s recent high, the Shiller price-to-earnings ratio (the S&P 500 divided by the 10-year average of inflation-adjusted earnings) of 24.6 matched that of September 1929 (a month before the crash that would lead to the 10-year Great Depression), exceeded the peak of 23 reached in March 1937 (the S&P 500 lost half of its value over the following year), matched the extreme of May 1965 (which ushered in a 17-year secular bear market) and significantly exceeded the level of 19.8 seen at the August 1987 peak (right before the global crash).

On the other hand, the bulls point out that the current Shiller P/E valuations are significantly lower than they were at the 2000 market peak. It doesn’t seem to matter to them that from the 2000 market peak to the present, the S&P 500 has achieved a nominal total return of only about 2.7 percent annually.

They also disregard the fact that 2000 ushered in a decade that included two 50 percent market declines: One in 2000-2002 that wiped out the entire total return of the S&P 500, in excess of Treasury bills, all the way back to May 1996; and the other in 2007-2009 that erased returns dating to June 1995.

A second point the bulls make is that the Shiller P/E broke above 27 at the late-2007 market peak, making the present reading of 24.6 seem not so high by comparison. But that occurred just before the market lost 55 percent of its value.

A final piece of evidence for the bulls is that stocks were already overvalued three years ago, when the market was at lower levels, so to see stocks advance from overvalued (three years ago) to extremely overvalued (today) further alleviates any cause for concern.

To the bulls, I say: “I hear you, but consider this — not only is the Shiller P/E at peak levels, but so are earnings too, which makes the Shiller valuation level even more alarming.”

In fact, corporate profits (measured as a percentage of GDP) are nearly 70 percent above their historical norms, which usually leads to subpar profit growth over the next four years.

That’s why it’s my view that none of the illusionary stock gains since the 2009 financial crisis will actually be retained by buy-and-hold investors once the current market cycle has been completed.

It’s important to recognize that valuation levels are most useful in forecasting future long-term returns, not short-term variations in market prices. That’s because market psychology dominates markets in the near term and investor emotion can trump valuations — but only in the short run.

I don’t believe stocks will decline immediately because investor sentiment is currently so overwhelmingly positive and the Federal Reserve’s monetary policies are so accommodating. But I also don’t anticipate a long continuation of the bull market.

For long-term investors, valuations are already at levels that imply low-single-digit returns for the U.S. stock market over the next decade, making it a bad decision to chase risky assets now, under conditions that have historically produced dismal forward-looking returns.

There’s no denying that stocks were overvalued some time ago, and they’re even more overvalued today. But we are where we are. That’s why it’s important to remember how extreme overvaluations have punished investors who held on too long.

Get your exit plan ready and guard your capital.

Best wishes,

Bill

Bill Hall is the editor of the Safe Money Report. He is a Certified Public Accountant (CPA), Chartered Financial Analyst (CFA) and Certified Financial Planner (CFP). Besides his editorial duties with Weiss Research, Bill is the managing director of Plimsoll Mark Capital, a firm that provides financial, tax and investment advice to wealthy families all over the world.