Nobel laureate economist Robert Shiller of Yale University says his indicator shows that the current stock market values are overinflated and will only crash even lower.
Shiller invented the cyclically adjusted price to earnings ratio (CAPE), a key indicator for stock market crashes.
“It is entirely plausible that the shaking of investor complacency in recent days will, despite intermittent rebounds, take the market down significantly,” Shiller wrote in the New York Times.
According to Shiller’s CAPE ratio, the stock market is significantly overvalued. The metric modifies historical price-earnings ratios to account for business cycles. Between 1881 and 2015, CAPE averaged a ratio of 17, well below today’s reading of 27.
“Levels higher than that have occurred very few times, including the years surrounding the stock market peaks of 1929, 2000 and 2007. In all three of these instances, the stock market eventually collapsed,” he said.
Shiller said his indicator would put the S&P closer to 1,300 from around 1,988 on Friday, and the Dow at 11,000 from around 16,643.
“We are in a rare and anxious “just don’t know” situation, where the stock market is inherently risky because of unstable investor psychology,” he said.
“There are reasons to question whether this was a quick, effective slap on the wrist, or if the market is still too overactive, and thus asking for a more extended punishment,” he said.
“Ten percent drops in the S&P 500 in just five trading days — such as what we just experienced — have not been common. Out of the 29 corrections since 1950, only nine happened in five days or less," he said.
"Most of those happened since 2000, possibly because of the Internet and faster communications. Such rare sharp drops are psychologically significant; an extreme one-day collapse seems to create anxiety that imprints on people’s memories and could contribute to a downward momentum.”
The CAPE is a valuation measure usually applied to the US S&P 500 equity market. It is defined as price divided by the average of ten years of earnings (Moving average), adjusted for inflation. As such, it is principally used to assess likely future returns from equities over timescales of 10 to 20 years, with higher than average CAPE values implying lower than average long-term annual average returns.
All of the recent market volatility could help drive investors away from stocks for years, says ace hedge fund manager Doug Kass
, president of Seabreeze Partners Management.
He lists several factors that could repel investors from equities in a commentary on TheStreet.com:
- "The Ongoing Bear Market." The stock drop was preceded by a plunge in commodity prices that has sent major indices to 16-year lows. Oil prices have hit six-year lows. "Big Oil and others hit by this bear market are often mainstays in retail investors' accounts," Kass writes.
- "A Broken Market Mechanism. The market's mechanism has been virtually destroyed by increased and more-costly regulatory burdens," Kass says. "These serve to limit dealer inventories in numerous asset classes and impair market liquidity, creating a vacuum that's taken up by leveraged ETFs and high-frequency trading strategies."
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