Earlier this week I posted a commentary ‘Is This Bull Market Fundamentally Driven? A Look at PE Expansion‘. The content was largely reprinted from an analysis at the Wall Street Rant website. Among the many email responses I received about the post, one in particular stood out. Jonathan Schoolar, a long-time veteran of the investment industry, wrote:
“Another, slightly less complicated way of looking at it is that bull markets go for as long as they go and for whatever reason. It is the terminal valuation that determines the degree of damage done in the subsequent bear market. Value must be reset, and the higher the starting point, the worse the decline when the bull driver ends.
Here is a quick look at the terminal Shiller P/E and subsequent declines using his info. Few data points but better “fit” than plotting the fundamental ratio. Bear markets from Shiller ratios above 20 are nasty.”
Jonathan’s email included a chart illustrating the cyclical P/Es at the peak before the 20% declines in the S&P 500 since its inception in March of 1957. Here is my annotated version of his chart. This is a scatter graph that uses the vertical axis to show the percent declines of the nine bear markets over this timeframe. The horizontal axis shows the cycle P/E ratio at the peak preceding the decline.
Because this type of graph doesn’t show the chronology, I’ve used callouts to indicate the date of the trough (market low) following the peak. The regression is a linear “best fit” though the nine data points. Only four of the nine are tight fits to the regression. The three bear markets in the 1950s and ’60s were less severe. The savage decline linked to the surge inflationary surge following the Arab Oil Embargo in 1973 was an outlier to the downside, as was the bear market associated with the Great Recession — the one still vivid in our memories.
I highlighted the market trough in 1970 because the cyclical P/E ratio of its preceding peak in November of 1968 was 22.2. That’s the same as the latest ratio in February of this year.
As Jonathan points out, “bull markets go for as long as they go and for whatever reason.” As I type this, our current bull in the S&P 500 is just a few points, about half a percent, from a new all-time high. Mainstream market mavens are increasingly bullish on US equities. For example, on Monday well-known analyst Meredith Whitney said: “I have not been this constructive and bullish on US equities in my career.” And of course we saw a cyclical P/E ratio north of 40 at the market peak in 2000.
At some point I hope to all another dot to the chart above. Where will it lie in the overall scatter? Only time will tell.
Appendix for Further Consideration
For a long-term look at the cyclical P/E 10 ratio, see my latest monthly update:
Here is a chart of the S&P 500 with callouts for bear markets declines to one decimal place. I’ve also included a pair of near bears.
Images: Flickr (licence attribution)
About The Author
My original dshort.com website was launched in February 2005 using a domain name based on my real name, Doug Short. I’m a formerly retired first wave boomer with a Ph.D. in English from Duke. Now my website has been acquired byAdvisor Perspectives, where I have been appointed the Vice President of Research.
My first career was a faculty position at North Carolina State University, where I achieved the rank of Full Professor in 1983. During the early ’80s I got hooked on academic uses of microcomputers for research and instruction. In 1983, I co-directed the Sixth International Conference on Computers and the Humanities. An IBM executive who attended the conference made me a job offer I couldn’t refuse.
Thus began my new career as a Higher Education Consultant for IBM — an ambassador for Information Technology to major universities around the country. After 12 years with Big Blue, I grew tired of the constant travel and left for a series of IT management positions in the Research Triangle area of North Carolina. I concluded my IT career managing the group responsible for email and research databases at GlaxoSmithKline until my retirement in 2006.
Contrary to what many visitors assume based on my last name, I’m not a bearish short seller. It’s true that some of my content has been a bit pessimistic in recent years. But I believe this is a result of economic realities and not a personal bias. For the record, my efforts to educate others about bear markets date from November 2007, as this Motley Fool article attests.