Stocks Could Fall 65% Based on Shiller PE

Stocks Could Fall 65% Based on Shiller PE
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Stocks Could Fall 65% Based on Shiller PE

by Rob Bennett

We have had four out-of-control bull market in U.S. history. The bear markets that followed the first three only ended after stock prices fell to one-half fair value. If this fourth one were to end in the same way, we will be seeing a price drop of 65 percent sometime over the next few years.

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Is it going to happen? How sure can we be?

I think the case is strong. However, I do not think the case is as strong as is the case that 10-year and 20-year returns can be predicted by looking at the P/E10 level that applies on the day a purchase of a broad index fund is completed.

We have good records of U.S. stock returns dating back to 1870. That’s 140 years of data. Valuations have been affecting long-term returns for that entire time-period. Valuations are not the only effect on returns. So we cannot predict returns with precision. But the statistical correlation is so strong and has applied for so many years that my view is that it is silly at this point to deny it. We know that valuations affect long-term returns with roughly the same degree of confidence that we know that the moon is not made of green cheese.

I believe that we are going to see a price drop of something in the neighborhood of 65 percent. But I don’t know this with the same degree of confidence that I know that the moon is not made of green cheese.

We only have three cases in which the P/E10 value fell to 7 or 8 following a runaway bull market. Taken by itself that’s not much evidence.

What makes the evidence somewhat compelling is the fact that we are three for three. That suggests a cause-and-effect relationship. A P/E10 level of 7 or 8 is a rare thing. Yet we always see it after a runaway bull market dies. The odds against that being mere coincidence are high indeed.

Consider for a moment what it means for stock prices to fall to one-half of fair value. It means that investors have of their own volition elected to price their portfolios at half of their real value.

Extreme overvaluation is a crazy phenomenon. But at least it can be said of extreme overvaluation that it serves our self interests. When we price stocks at two times fair value, we are fooling ourselves into thinking we are richer than we are. That’s not a smart or responsible thing to do. But there’s a certain logic at work in the act of pretending we possess far more in the way of wealth than we really do possess.

What could ever cause us to pretend the opposite, that we possess far less in the way of wealth than we really do possess? Undervaluation is twice as odd a phenomenon as overvaluation.

So we don’t see it much. Yet we always see it in the aftermath of runaway bulls. That reality is so odd as to demand an explanation.

My explanation is that the drop in prices that inevitably follows a runaway bull causes an economic crises. The price drop leaves people with less money to spend and the cutback in spending causes a mass of  business failures. The overvaluation was pretend stuff, but the business failures are only too real. The economic crisis sends prices down far below fair value because the real economic pain causes investors to doubt whether a recovery ever will come.

We are pretending when we send prices down to one-half fair value. But we aren’t pretending out of a desire to make ourselves happy. We are pretending because we are in such pain that we can no longer bear to entertain hopes for the future. There are people who turn down promotions for which they are perfectly qualified because they cannot bear to entertain that possibility that good things could happen in their lives. That’s the sort of emotional state that sends P/E10 values down to 8.

The statistical evidence that we will see a drop to 8 is not as strong as the statistical evidence that valuations affect long-term returns. But the logic that explains the bull/bear cycle requires such a drop.

There’s another sort of evidence that I find persuasive. I spend a lot of time talking over investing topics with investors who contribute to blog threads and discussion boards. I have been witnessing intensely emotional reactions to Shiller’s ideas for 10 years now. For so long as investors remain this emotional, I will believe that we are in danger of big price drops. It is just not healthy for investors to become as emotional as they have become in the Buy-and-Hold Era.

Could we avoid the 65 percent price drop, a price drop so large that it is likely to send us into the Second Great Depression?

My view is that investors will regain their confidence in their financial futures once we find a way to spread the word about Shiller’s findings and to help investors understand that it is possible today to earn far higher returns while taking on dramatically reduced risk. So the 65 percent price drop is not a certainty. It is something that we are highly likely to see only in the event that we remain too much longer on the current course.

It’s up to us, the humans, as to whether we really enter the dark days that the historical record suggests is our fate. That is as it should be. That’s the drama of the thing.

Rob Bennett recently posted a review of the book The Myth of the Rational Market. His bio is here.

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Rob Bennett’s A Rich Life blog aims to put the “personal” back into “personal finance” - he focuses on the role played by emotion in saving and investing decisions. Rob developed the Passion Saving approach to money management; Passion Savers save not to finance their old-age retirements but to enjoy more freedom and opportunity in their 20s, 30s, 40s, and 50s - because they pursue saving goals over which they feel a more intense personal concern, they are more motivated to save effectively. He also developed the Valuation-Informed Indexing investing strategy, a strategy that combines the most powerful insights of Vanguard Founder John Bogle and Yale Professsor Robert Shiller in a simple approach offering higher returns at greatly diminished risk. Tom Gardner, co-founder of the Motley Fool web site, said of Rob’s work: “The elegant simplicty of his ideas warms the heart and startles the brain.”

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