Don't Be Surprised If This Is The Start Of A Stock Market Crash ...

new york stock exchange traders crash

Stocks are tanking again. The sudden dives in recent weeks have taken the tech-heavy Nasdaq down 7% from its highs and the S&P and Dow about 3% from their highs. Drops like that are no big deal. But some signs suggest that this pullback — or another one sometime soon — could get much more severe. Why?

Three basic reasons:

  • Stocks are still very expensive
  • Corporate profit margins are at record highs
  • The Fed is now tightening

Let's take those one at a time.

First, price.

Even after the recent drops, stocks appear to be very expensive.

The chart below is from Yale professor Robert Shiller. It shows the cyclically adjusted price-earnings ratio of the S&P 500 for the last 130 years. As you can see, today's P/E ratio of 25X is miles above the long-term average of 15X. In fact, it's higher than at any point in the 20th century with the exception of the peaks of 1929 and 2000 (you know what happened after those).





Does a high PE mean the market is going to crash? No. But unless it's "different this time," a high PE means we're likely to have lousy returns for the next seven to 10 years.

By the way, in case some of your bullish friends have convinced you that Professor Shiller's P/E analysis is flawed, check out the chart below. It's from fund manager John Hussman. It shows six valuation measures in addition to the Shiller P/E that have been highly predictive of future returns over the past century. The left scale shows the predicted 10-year return for stocks according to each valuation measure. The colored lines (except green) show the predicted return for each measure at any given time. The green line is the actual return over the 10 years from that point (it ends 10 years ago.  Today, the average expected return for the next 10 years is slightly positive — about 2% a year. That's not horrible. But it's a far cry from the 10% long-term average.




So that's price. Next comes profit margins.

One reason stocks are so expensive these days is that investors are comparing stock prices to this year's earnings and next year's expected earnings. In some years, when profit margins are normal, this valuation measure is meaningful. In other years, however — at the peak or trough of the business cycle — comparing prices to one year's earnings can produce a very misleading sense of value.

Have a glance at this recent chart of profits as a percent of the economy. Today's profit margins are the highest in history, by a mile. Note that, in every previous instance in which profit margins have reached extreme levels — high and low — they have subsequently reverted to (or beyond) the mean. And when profit margins have reverted, so have stock prices.


profits as a percent of GDP

Business Insider, St. Louis Fed

After-tax profits as a percent of GDP.




Now, you can tell yourself stories about why, this time, profit margins have reached a "permanently high plateau," as a famous economist remarked about stock prices in 1929. And you might be right. But as you are telling yourself these stories, please recognize that what you are really saying is "It's different this time." And "it's different this time" has been described as "the four most expensive words in the English language."

And then there's Fed tightening.

For the last five years, the Fed has been frantically pumping money into Wall Street, keeping interest rates low to encourage hedge funds and other investors to borrow and speculate. This free money, and the resulting speculation, has helped drive stocks to their current very expensive levels.

But now the Fed is starting to "take away the punch bowl," as Wall Street is fond of saying.

Specifically, the Fed is beginning to reduce the amount of money that it is pumping into Wall Street.

To be sure, for now, the Fed is still pumping oceans of money into Wall Street. But, in the past, it has been the change in direction of Fed money-pumping that has been important to the stock market, not the absolute level. 

In the past, major changes in direction of Fed money-pumping have often been followed by changes in direction of stock prices. Not always. But often.

Let's go to the history ...


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commented 2014-04-12 13:37:16 -0400 · Flag
TN writes:

I wish I could be encouraged by the empirical data points highlighted in this article,
the Market sell-off/pull back at this point in non-existent.

The Federal Reserve is still creating $55.0 Billion out of Thin Air Every Month,
as previously commented to you, I think they are on the verge of Ending there Taper,
market dislocation like this past week Only reinforces that likely course of action.

Interest rates are Not Going to Normalize.

Anything even remotely resembling Rising Interest Rates will result in Immediate Economic Collapse, the entire fiasco leading up to the September 2008 meltdown was Excessive Leverage, What has happened over the course of the past 5 years has been an Even Bigger expansion of Debt/Leverage or the perpetual Roll-over of existing debt of Zombie Governments & companies.