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Posted on 12 April 2011 | 6,211 views

Stock Crash Indicator Same as October 1929 and October 2007 for 2011

There have been only four other occasions over the last century when stock market valuations were as high as they are now, according to a variant of the price-earnings ratio that has a wide following in academic circles.

Stocks on each of those four occasions would soon suffer big declines.

This modified P/E was made famous in the late 1990s by Yale University professor Robert Shiller, particularly in his book “Irrational Exuberance” — in this modified P/E, the denominator is not current earnings per share but average inflation-adjusted earnings over the trailing 10 years. This modified ratio — sometimes called P/E10, or CAPE (for Cyclically Adjusted Price Earnings ratio) — has a markedly better forecasting record than the simple P/E.

According to Shiller’s website, the CAPE currently is 23.5, or some 43% higher than the CAPE’s long-term historical average. The four previous occasions over the last 100 years that saw the CAPE as high as they are now:

• The late 1920s, right before the 1929 stock market crash

• The mid-1960s, prior to the 16-year period in which the Dow went nowhere in nominal terms and was decimated in inflation-adjusted terms

• The late 1990s, just prior to the popping of the internet bubble

• The period leading up to the October 2007 stock market high, just prior to the Great Recession and associated credit crunch

To be sure, a conclusion based on a sample containing just four events cannot be conclusive from a statistical point of view. Still, it will be hard to argue that the current stock market is undervalued or even fairly valued.

One popular attempt to sidestep the conclusion is to argue that today’s rock-bottom interest rates justify much-higher-than-average stock valuations. But there is precious little historical evidence to support this argument.

In fact, according to econometric tests conducted by Clifford S. Asness, managing and founding principal at AQR Capital Management, a Greenwich, Conn.-based quantitative research firm, the P/E ratio’s explanatory power goes down, not up, when the ratio is adjusted according to prevailing interest rates.

Perhaps the bulls’ best argument, in the face of the current high CAPE level, is to point out that valuations can remain high for some time before they come back down to earth. The CAPE at the height of the Internet bubble in early 2000 was above 40, for example. And it was above 30 right prior to the 1929 stock market crash. Compared to those two lofty levels, the current CAPE might suggest that the bull market still has room to run.

Nevertheless, one can’t help but notice that the bulls are on shaky ground if their best argument requires drawing analogies to the two occasions in the past when stocks were more overvalued than they ever were, either before or since.

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