Just what will pop market exuberance?

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2 mins. to read

By Filipe R. Costa

When it comes to rationalising the current bull market, the list of incredulous market observers just keeps growing. Earlier in the week I wrote about Robert Shiller’s sharing of this year’s Nobel Prize for Economics. With this in mindm it is worth examining current stock valuations using his seminal work, the Case-Shiller P/E Index.

The latest reading of this P/E measure suggests prices are 50% above their long-term means.

To calculate the Case-Shiller P/E index it is deflated to account for real changes in earnings. It uses 10 years of earnings data to reduce the ‘noise’ created by the business cycle. Using the Case-Shiller P/E against historical data shows a clear tendency for mean reversion within the index. This goes back to 1881. As the index has risen too high or fallen too low then as night follows day it has regularly reversed.

The explanation for this consistent pattern is relatively simple. When the ratio starts rising from its long term mean, then stock prices are rising faster than earnings. Investors pay more dollars for each dollar of earnings the company can generate. The company (or even market) becomes more and more overvalued the longer this part of the process continues. To restore equilibrium then earnings have to grow faster than prices. This can happen gradually, but as is often the case, the market can reset much more suddenly, through a crash.

Such crashes occurred in 1929, 2000 and 2007, as you can easily see in the chart below:

By the early 1990s the Case-Shiller P/E index was already approaching its highs. At this point it would have been reasonable to expect a reversion. However, then the Tech Bubble happened. When this burst in 2000, we could have expected the Case-Shiller P/E Index to correct to the low teens or lower. But, the Fed stepped in…

In its obsession with keeping financial asset prices high the Fed began its policy of distorting markets at the start of the Century. The long-term mean for the Case Shiller P/E Index was about 16.5, but Fed policy kept prices higher at about 23. This was just one consequence of events that lead to the Housing Bubble, and when this burst, the Fed stepped in once again. Through its policies of asset purchases and near-zero interest rates, the Case-Shiller P/E fell no further than below 15, during what was meant to be the worst financial crisis in 80 years!

Now the Case-Shiller P/E ratio is back up to 24.5.

The question now is what might come next?

Well, part of the answer should be obvious. With more money circulating and the same capacity in place, this will almost certainly lead to another bubble. And, as always happens with bubbles, they burst. The Fed could keep printing and stocks could keep rising. This is perfectly possible, but for anyone taking a long-term view on their money, the risks should be apparent. During the 1990s the Case-Shiller P/E persisted above its long term average for nearly a decade. When it corrected it did so aggressively. A key difference between then and now, however, is that in response to that crash central banks had options to choose from. With interest rates already at zero and central bank balance sheets as overblown as they already are, the next time around they are not likely to do this.

And at that point market forces might actually start to exert themselves on this strange, distorted world we now live in. 

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