Stock Market Bubbles In Perspective (Or Why “This Won’t End Well”)

Thursday, September 21, 2017
By Paul Martin

by Howard Ma via Meritocracy Capital,
Sep 21, 2017

Last week marked the 9th anniversary of the collapse of Lehman Brothers. It was one of the biggest milestones of the Global Financial Crisis (“GFC”) that began approximately a year earlier in 2007. Corporate earnings were abnormally weak during the GFC. I bring that up because a much cited stock market valuation metric that has been prescient gauging past bubbles could be overstated due to those abnormally weak earnings. Those of you concerned about the valuation of the U.S. stock market should read on.

What Does Average Mean?
The cyclically-adjusted price-to-earnings (“CAPE”) ratio is normally credited to Nobel-prize winning economist Robert J. Shiller. It adjusts for the ups and downs of business cycles by comparing the price of the S&P Composite Index to the average, annual inflation-adjusted earnings of that index over the previous 10 years. There are three types of averages: mean, median and mode. The type of average the CAPE ratio uses is the mean (a.k.a. arithmetic mean). Though the CAPE ratio has been shown to be a reliable predictor of future long-term stock market returns, it has also been widely criticized.

One criticism is that the CAPE ratio is susceptible to outliers. For example, those abnormally weak earnings that occurred during the GFC drag the mean, annual inflation-adjusted earnings down. This could make the CAPE ratio of the S&P Composite Index look more expensive than it may actually be. It has been widely reported that the CAPE ratio is currently at a very high level behind only two other stock market peaks: 1) the Tech Bubble, and 2) the stock market bubble that occurred during the Roaring Twenties (immediately preceding the Great Depression). In both cases, the stock market eventually crashed and in spectacular fashion.

One way to adjust for this problem of abnormally weak earnings is to instead use the peak earnings of the past decade. This approach has been credited to investment manager John Hussman. Ironically, the lesser known Hussman P/E currently shows that the S&P Composite Index is at a very expensive level second to only the Tech Bubble. Those who argue the U.S. stock market is not expensive don’t care for this approach.

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