Crash or correction? Shiller P/E crosses all important 25 level

A running theme here at Spreadbet Magazine has been this market’s refusal to revert to the mean. Mean reversion is the quintessential characteristic of price movements but thanks to the hugely distortive effects of quantitative easing, today’s investors/traders/speculators seem largely to have forgotten this. At some point they will be reminded of it, but the question is will this be in the form of a crash or a correction?

As things stand now, I am going to bet on there being a correction, not a crash. I’m certainly not suggesting shorting this market, but rather waiting until a decent opportunity presents itself to get long again.

Earlier in the summer, I had some pretty good trades shorting US indices, when the Hindenburg Omen surfaced. However, that signal for a pending significant correction proved to be false and the pullback was only slight. Now, retail money is piling back into the market and the Fed’s taper doesn’t look like it is going to happen in the near future, so we are back off to the races on a wave of euphoric optimism.

As is ever the case, there are parallels between what is happening today and what has happened before. Historical precedent suggests we have entered the final stages of this bull market, but the giant elephant in the room is the Fed’s bond purchasing programme. Even if they do start to taper, a taper is a reduction not a resolution. As long as the market continues to believe in quantitative easing (and it really isn’t much more than a parlour trick) then stocks can continue to go up.

This said, we are in truly unchartered territory. The Japanese experience of the early 1990s point to the ineffectiveness of the Fed’s current policies. Printing money to shore up a failing system does nothing to resolve its structural weaknesses. America could well be halfway through its first “lost decade” and there could even be a second one to follow. The end to all this is likely to be pretty bad for that country’s preeminent position in the world’s economy, but this is not necessarily a disaster in itself. However, predicting specifically when this might happen is folly. Realistically, the best most of us can hope for is to apply some broad strokes and hope our forecast matches up at least a little with reality.

For my two pence worth, I am keeping a close eye on the Shiller P/E ratio, below;

Regularly used by my colleague Filipe Costa in his analysis of US stocks, the Shiller P/E is generally regarded as a more accurate measure of comparing stock prices to earnings. More can be read about the Shiller P/E here, but for now I want to focus on its current level.

As the chart above shows, the Shiller P/E recently moved above 25. It has only ever done this four times before, twice in the last two decades. Whenever this ratio has crossed this point, a market crash has followed. In the two most recent examples of this price action the crash has taken a few years before it occurred, but it occurred nevertheless (the Dotcom Crash and the Great Financial Crisis).

Writing today, the Shiller P/E at 25 does not mean we are about to see a crash. Corporate earnings remain robust and with the Fed keeping interest rates at unsustainably low levels there is no reason to doubt their resilience for the first half of next year. With a very short term outlook, I believe it will be “safe” to continue buying stocks until the Shiller P/E hits 30. My logic is quite simple. Unlike the late 1990s, when simply owning a website put a staggering multiple on your stock price, this market is built on earnings. As questionable as the source of these earnings is (i.e. unsustainably low borrowing costs), they still exist. If there is a taper-related pullback and the Shiller P/E hasn’t gone above my target, then this could provide the opportunity to go long, which I am looking for.