Three Scenarios for What We May See Following the Next Price Crash

Valuation-Informed Indexing #316

by Rob Bennett

I believe that we will be seeing another stock price crash within the next year or two or three. The reason is that I believe that Robert Shiller’s 1981 research finding that valuations affect long-term returns shows that price changes are not caused by unforeseen economic developments but by shifts in investor emotion. Investor emotion changes follow a predictable long-term path. The extent of irrational exuberance increases for about 20 years and then diminishes for about 15 years and then the cycle begins again.

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The reason why valuations continue upward for about 20 years is that that is their natural direction. We all carry a Get Rich Quick urge within us; we all desire something for nothing. In most areas of endeavor, it is not possible to find something-for-nothing propositions. But in the stock market it is entirely possible. Stock investors can vote themselves wealth increases and there is no penalty exacted on them for doing so for a long time. So they do so. They vote themselves a wealth increase by pushing valuations upward, see that nothing bad happens as a result, and then do it again. And then again. Until valuations reach two times the fair-value level or more.

At that point, our common-sense instinct (which we also all possess) kicks in. We continue on one level of consciousness to believe that the numbers reported on our portfolio statements are real. But we also come to harbor doubts that the party can continue indefinitely. At this point, stocks become an exceedingly risky investment choice. Large numbers of investors form plans to sell at the first sign of trouble, and when trouble arrives, a cascade of selling brings on a price crash.

It takes years for investors to get past the negative feelings about stocks experienced by those who lose a large portion of their life savings in a matter of days. Only after a significant stretch of time passes does the Get Rich Quick urge become strong enough for investors to begin pushing valuations upward again.

There has never been a bull/bear cycle that ended before the P/E10 level fell to 8 or less, a two-thirds drop from where it stands today. So, in the event that stocks continue to perform in the future anything at all as they always have in the past, we should be expecting another price crash sometime in the next few years. The downward movement in valuations that began in 2000 was interrupted in 2009, when the Federal Reserve took steps to reassure frightened investors that it would not permit the crash that began in late 2008 to become too devastating. Reality usually assets itself after the passage of ten years or so, so the best estimate that we can make of when the crash will take place is that it should happen before the passage of another two to three years of time.

How will we react?

I see three possibilities.

One possibility is that we will respond to the next crash as we have to all previous crashes. That is, we will blame it on economic or political developments rather than on the overvaluation that makes crashes inevitable. This would be most unfortunate. The worst crash that we have seen is the one that began from the highest valuation level that we saw prior to the current bull/bear cycle. That was the P/E10 level of 33 experienced just prior to Black Friday in 1929. In January 2000, we hit 44. If nothing happens different this time, we could experience a Second Great Depression. This possibility is too horrible to contemplate in any detail.

Fortunately, Shiller published the research that points to a new understanding of how stock investing works in 1981. The bull market has blocked an appreciation of Shiller’s findings from spreading too far over the course of the past 35 years. But that hold-up will likely be overcome when investors experience the reversals associated with the loss of trillions of dollars in spending power. So there is no need for the next crash to lead us down so dark a path. This second, more promising scenario, is the most likely one, in my assessment.

My guess is that we will see widespread panic as the first reaction to the next price crash but that the panic will cause many leaders in this field to take up serious and extensive discussion of the implications of Shiller’s findings. Shiller’s work shows us how to reduce stock investing risk dramatically while helping our capitalist economy operate with more stability as well; we will be enjoying the positive impact of 35 years of powerful research-based insights realized over the course of a few years. My guess is that we will see an economic surge that will bring a quick end to the economic turmoil brought on by the crash.

The third scenario is that we could see an economic hit strong enough to bring on a significant recession but not so strong as to bring on a Second Great Depression; there is a range of possibilities that follow from any P/E10 level so it is at least possible that we could avoid another Great Depression even in a bear market initiated by a P/E10 level of 44. The unlucky side of this generally lucky outcome might be that experts in this field would continue to hold back on the launching of a national debate re the implications of Shiller’s findings (out of embarrassment of the role that they played in delaying the national debate for so many years). In that case, we would likely see a more drawn-out recession, followed in time by another bull market and then of course another crash many years down the road.

In the more positive scenario (the second of the three outlined above), investors would learn that the key to effective long-term stock investing is the exercise of price discipline and prices would be greatly stabilized from that point forward as each uptick in valuations brought on enough sales to pull stock prices back close to fair-value levels and as each downtick brought on enough purchases to pull stock prices back close to fair-value levels.

Rob’s bio is here.