When Will We See the Next Price Crash?

Valuation-Informed Indexing #110

by Rob Bennett

The truth is that I don’t know when we are going to see the next price crash. Valuation-Informed Indexers believe that stock prices are determined by investor emotion and that investor emotion is unpredictable. So we don’t pretend to know when price changes will come.

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The annoying thing is, we believe that we can say with a high degree of confidence that a price crash is coming. Stock prices always drop to one-half of fair value (a P/E10 value of 7 or 8) in the secular bear market that inevitably follows a secular bull. The reason is that the drop to fair-value prices causes an economic crisis and the economic crisis causes investors to give up hope. So I often warn investors not to buy heavily into stocks at today’s prices, prices from which we will see a 65 percent price drop if we once again end up at a P/E10 of 7 or 8.

The Buy-and-Holders want to pin me down. They want me to say that the price drop will come by such and such a date. That way, if my prediction doesn’t pan out, they can dismiss everything I say as nonsense. I see where they are coming from. It is indeed annoying for someone to say that he is sure that a big price drop is coming but not to give specifics as to when. I believe that in fairness I ought to try to at least offer some sketchy thoughts.

If we don’t see that price drop in five years, I’m wrong. I can give them that much. I’m not boxing myself in too much with that statement. But I think it’s about the most specificity that I can offer.

I feel confident saying that much because the reason for the price drop is the change in investor emotion that comes with the realization that the bull market prices were phony and unrealistic. That realization doesn’t take place all at once. So we do not see prices return to fair value levels and then stay there; we see prices gradually work their way downward. It’s perfectly reasonable for that process to take years to complete itself. But the number of years should not be indefinite if it really is so that investor emotion determines stock prices.

Stock prices reached insanely dangerous levels in January 1996. That’s nearly 17 years ago. The bull hit its top in January 2000. That’s nearly 13 years ago. The crash came in September 2008. That’s nearly four years ago. It shouldn’t take five years more for this emotional unwinding to complete itself. If it does, Valuation-Informed Indexing skeptics have good reason to feel confirmed in their skepticism.

My hunch is that we will see a big price drop by the end of 2013. I don’t think hunches are worth much and I don’t believe that the academic research permits us to offer more than hunches on the timing of the price drop. But that’s the hunch in any event.

The historical data does tell us not to be surprised to see more than one further price drop. We are today at a P/E10 value of 23. If we are going to end up at 8, we will be seeing a price drop of about 65 percent. But it is entirely possible that we will see within the next three years one drop to a P/E10 level of 12 or so and then another drop to 8 or so a few years later.

There are all sorts of effects that might come with the election.

An election of Romney might cause investors to feel more hopeful because this would represent a change. That might push off the price crash a bit. A second way in which a Romney election might push off a crash is that investors might feel that Romney needs two years to put his policies into place and thus might be able to ignore bad economic developments that took place early in a Romney Administration.

However, good economic developments early in a Romney Administration might be dismissed. The thinking might be that good developments that are the result of Obama policies don’t represent much of a positive signal if Obama is no longer around to extend those policies. Paradoxically, good economic developments that come early in a Romney term might be viewed by some investors as a cause for regret at having rejected the fellow who brought about the positive developments.

No matter how big the price drop or when it comes, analysts will attribute it to economic or political developments. We like to think we know what is going on. We like to think that we are on top of things. We like to be able to ascribe changes in stock prices to specific and recent developments.

The far more likely reality, according to the recent research, is that the price drop will be the result of investor emotions experienced 10 years earlier. Prices don’t change because of what happens today. They change because of what happened many moons ago and because we have with time come to experience a side of the story that we denied ourselves in that earlier era. That’s why we are able to say with a good measure of confidence what is going to happen while we are not able with much confidence to say when the changes we predict will take place.

Rob Bennett has written an article titled The Buy-and-Hold Crisis. His bio is here.