The market’s cycle of bull and bear markets is mostly the result of investors paying higher multiples for earnings during bull markets and lower during bear markets. If investors paid a steady multiple of corporate revenue the market would slowly climb over the years. Wall Street would hate this.
Investors are willing to pay higher multiples when earnings growth is high. The fact that the highest earnings growth often comes after plunges in earnings is lost on those same investors who project high earnings and index growth into the future. They of course are helped in their unrealistic projections by analyst predicting high earnings growth even as the markets and earnings are in decline.
Earnings Growth and Low Volatility
American Nobel Laureate and economist, Robert Shiller, added some perspective on his now famous Shiller PE also called the CAPE. The current CAPE is 30 and was only higher at the top of the 1929 and 2000 stock market bubbles. The average CAPE since 1871 is 16.8 nearly half of its current level.
With the financial media talking of decent earnings growth and equating low volatility in the markets with low risk, Robert Shiller decided to compare current conditions to those years leading into the last 13 bear markets. In other words, does strong earnings growth and low volatility negate the possibility of a bear market in the near future.
Robert admits that a high CAPE does not tell us when the market is going to top, but it does a pretty good job of predicting future returns. A high PE means lower future returns and a low PE means higher returns. The current CAPE points to very low future returns.
The last 13 bear markets
Robert Shiller analyzed the markets leading up to the last 13 bear markets since 1871 for similarities. He defined a bear market as when the market trades 20% below its high within 12 months. Here is what he found:
- The peak months prior to a bear market had an average CAPE PE of 22.1 (we are at 30 today).
- The three times bear markets started with below average CAPE PEs were during WWI, after WWII, and during the Great Depression.
- The peak months prior to past bear markets tend to show high real earnings growth: 13.3% per year on average for all 13 episodes. Leading into 1929 real earnings growth was 18.3%.
- Current real earnings growth is 13.2%
- Average real earnings growth since 1871 has been 1.8% per year.
- Current average stock-price volatility is an extremely low 1.2%.
- This is presented as good news – low perceived risk
- The peak months leading into bear markets were also lower than average
- Leading into the 1929 crash volatility was only 2.8% below the average 3.5%
Robert is not calling a top. He is simply warning against complacency because the market’s narrative is positive. It is always positive at tops.
From his work it appears that high earnings growth is a prerequisite for a market top and bear market. Real earnings growth rates over 13% imply the need negative earnings growth to bring the average down to only 1.8%. This cycling of earnings is amplified by multiple expansions and contractions – bull and bear markets.
The current leg up in the market is due primarily to a multiple expansion (higher CAPE) and higher corporate leverage. Corporate profits today are at the same level they were in late 2011. Higher corporate leverage (debt) allowed corporations to buy back their own stock giving the appearance of growth through higher earnings-per-share. These bull market extending gimmicks will be costly during the next bear market.
So I agree with Robert Shiller’s underlying message… Investors taking on too much stock-market risk today may be nursing considerable losses in the future.
If you are interested in reading more about how to buy high and sell low you can view Into Thin Air. Corporate Profits versus Corporate Profits discusses how corporate profits and earnings growth are not always what they appear to be.
If you just want warnings on when the next bear market or deep market correction appears imminent, you can learn about TSP & Vanguard Smart Investor.