Is a stock market crash likely? These 5 measures say it
What a difference a year makes! About 13 months ago, on March 23, 2020, the stock market was in turmoil as fear and uncertainty peaked around the pandemic. It only took 33 calendar days for the benchmark S&P 500 (SNPINDEX: ^ GSPC) to lose 34% of its value.
But over the next 13 months, investors saw a historic rebound. Until April 21, 2021, the widely followed index had risen almost 87% on a nominal basis, or around 88% if you include dividends paid. Although I am selecting the fund here, it’s a ridiculously good return considering that the S&P 500 has averaged a total annual return of just over 10% since 1980.
The question is: are things too good? According to five parameters, they could be.
While it is impossible to accurately predict when a stock market crash will occur, how long it will last, or how steep the decline will be, these metrics all seem to imply that the likelihood of a crash or serious correction increases. through the day.
1. The history serves as a warning for the S&P 500 P / E Shiller report
Perhaps the biggest red flag from a fundamental standpoint is the Shiller Price / Earnings (P / E) ratio of the S&P 500, also known as Cyclically Adjusted P / E, or CAPE. Shiller’s P / E is based on the inflation-adjusted average earnings of the previous 10 years.
As of April 21, Shiller’s P / E ratio for the S&P 500 was 37.49. That’s well over double its average annual reading of 16.81 since 1870.
What is of particular concern is what happened previously when Shiller’s P / E ratio went over and stayed above 30. In the previous four cases (the Great Depression, the dowry boom) com, the fourth quarter of 2018 and the coronavirus crash), the S&P 500 lost between 20% and 89% of its value. While an 89% loss is highly unlikely, with the Federal Reserve and Federal Government willing to provide seemingly limitless support to financial markets, a large double-digit correction has become the expectation when valuations significantly exceed historical norms. .
2. The price / sales ratio of the S&P 500 is extremely high
A second reason for concern is in the S&P 500 price-to-sell (P / S) ratio. This ratio describes the value of the S&P 500 Index relative to the overall sales of its 500 constituents. As a general rule, the lower the price-to-sell ratio, the more inherently attractive an investment.
As of April 21, the S&P 500 price-to-sell ratio was estimated at 3.06. It’s an undisputed highlight that dates back at least 21 years. In fact, the P / S ratio of the S&P 500 had not ended the year above 2 at any time in this century before 2017. Since the end of 2018, the P / S ratio of the index has been widely followed. increased by 64%.
On the one hand, increased use of technology should allow companies to be more efficient, thus increasing their operating margins. On the other hand, there is no historical indication that such high P / S ratios can be sustained.
3. The book value of the S&P 500 is problematic
A third metric that could set off warning bells is the S&P 500 price-to-book (P / B) ratio. It is a measure of the S&P 500’s market capitalization divided by the book value of stocks that make up the index. Like the P / S ratio, a lower value usually indicates that a stock or index is undervalued.
Since last week, the book value of the S&P 500 has exceeded 4.5. This is approaching the highest level reached this century, 5.06, in March 2000. If March 2000 rings a bell, it is because that is when the dot-com bubble peaked. In some contexts, the average P / B value over the past 21 years is 2.87.
Although the P / B ratio has lost much of its importance as technology and innovation have taken hold, it is still of concern that the index has subsequently lost about half of its value last. times the ratio was this high.
4. S&P 500 earnings yield is not attractive
The fourth worrisome measure is the return on earnings of the S&P 500. While the price / earnings ratio is a measure of the stock price divided by the earnings per share, the earnings return is the earnings per share divided by the price of. action and multiplied by 100 to give a percentage.
Since 1870, the average return on earnings of the S&P 500 has been 7.31%. This is much higher than what investors can typically generate from bonds, which is why stocks are often such a smart and desirable investment. But as of April 21, the S&P 500 earnings return was a measly 2.35%. It has been cut by more than half since the start of 2019, when it was 5.1%.
The problem here is that 30-year Treasuries have an almost identical yield (2.26%). While profits may increase over time and improve the return on S&P 500 earnings, it should be assumed that, with historically low lending rates and ongoing fiscal stimulus, earnings growth will not grow. will be no better than it is now. Future earnings growth could slow due to the tightening of accommodative monetary policy, exposing an unattractive risk / reward ratio with bonds.
5. The frequency of the two-digit percentage corrections is an alarm signal.
Finally, don’t overlook the frequency of double-digit declines in the benchmark.
Since the start of 1950 (a year I chose arbitrarily for the sake of simplicity), there have been 38 drops of at least 10%. This corresponds to an average double-digit decline every 1.87 years. We are already about 1.1 years from the bottom of the bear market.
Understand, however, that averages are just that: averages. Sometimes the market can go an unusually long time without a single 10% correction (1991 to 1996), while other times they become an annual occurrence (1997-2003, with the dot-com bubble running from 2000 to 2002) . The point is this: Fixes and / or crashes happen often.
Crashes are blessings in disguise
These five measures seem to point to an inevitable conclusion: the likelihood of a stock market crash or double-digit correction is quite high. This may be overwhelming for some, but it’s actually great news for investors with a long-term mindset.
Every crash and fix throughout history has been a blessing in disguise. This is because investors trade short term pain for long term gain.
Eventually, every double-digit decline in the S&P 500 was completely wiped out by a rally in the bull market. If you buy big companies when emotion-based crashes get you cracked and hang on to them for long periods of time, there’s a very good chance you’ll get rich over time. While it’s not normal to see 88% total returns in 13 months after a crash, a double-digit annualized total return over the long term is entirely possible.
This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a premium Motley Fool consulting service. We are motley! Questioning an investment thesis – even one of our own – helps us all to think critically about investing and make decisions that help us become smarter, happier, and richer.