It is a truism of the investing world that markets move in cycles, with a bull market inevitably ending in a bear market downturn if not a crash. The current bull market broke records for the longest-lasting ever and for the best-performing since World War II way back in November 2019. There was a short-lived market crash, known as the Coronavirus Crash, in early 2020. It was forgotten by early April and the bull run kept rolling through the depths of a global pandemic, a volatile election season, the second impeachment of a president, and a mob invasion of the U.S. Capitol.
Now, everyone is waiting for the next big dip. But how do you spot it before it hits? One way is by looking at the CAPE ratio, devised by the Nobel Laureate economist Robert Shiller of Yale University to measure whether a stock's price is moving up faster than the company's earnings can justify. Some use the CAPE ratio to determine whether the markets as a whole are undervalued, in which case they should go higher, or over-valued, which suggests they're headed for a crash.
The CAPE ratio for the S&P 500 Index at the end of January 2021 stood at 33.74. It hit a then-record of 28 just before the market crash of 2008.
- Boom and bust cycles are a fact of life on Wall Street. The Great Crash of 1929 was a particularly dramatic example.
- One number that some consider a predictor of a crash is the CAPE ratio for the S&P 500 Index.
- This number compares the current level of the S&P 500 to the average earnings of its components over the past 10 years.
- A high number indicates that stocks may be overpriced and due for a crash.
- The number at the end of 2020 was higher than it was before the Great Crash of 1929 but lower than it was before the Dot-Com Bust.
Understanding CAPE and Stock Market Crashes
The price-to-earnings ratio, or P/E, is one of the most important measures of the current value of a stock. It is the current price of the stock compared to its earnings per share. Investors look at two versions of it, one comparing the stock's price to its earnings over the past 12 months and a second comparing its price to its projected earnings for the next 12 months.
The average stock has a P/E ratio of about 15x, or 15 times greater than its earnings. The higher the number, the pricier the stock looks. The lower the number, the better a buy it appears to be.
The cyclically-adjusted price-to-earnings ratio, or CAPE, is a variation on this formula, which is why it's sometimes called the Schiller P/E ratio or P/E 10. It compares a stock's current price to its real earnings per share averaged over the past 10 years and adjusted for inflation. That smooths out the gyrations of the market, presumably giving a more realistic view of whether a stock is over-priced or under-valued given its real performance over time.
The CAPE ratio can be extended to the markets as a whole, or to a reasonable representation of the markets such as the S&P 500 Index. Tracking the number through history, you can see that the number hit a then-record 30 just before the Great Crash of 1929, after which it fell to single digits. It climbed to a record near 45 just before the dot-com bust of 2000 before falling to 15. By the end of 2020, it stood at 33.82.
Drawbacks of CAPE
In retrospect, it appears that the CAPE ratio accurately predicted the Great Crash of 1929 and the dot-com bust. Even if it did, there are no firm trading rules for investors that can be developed from the CAPE number that can tell them precisely when to buy or when to sell. It may prove right again. Or not.
"It's one thing to construct forecasts after the fact when viewing the established history, but quite another to do so before the data arrive," notes John Rekenthaler, vice president of research for Morningstar.
And, it should be noted that Shiller himself said in early December 2020 that stock prices "may not be as absurd as some people think." He cited the effects of extremely low interest rates in making stocks attractive at higher prices, especially in comparison with bonds.
Robert Shiller, the economist behind the CAPE ratio, said in late 2020 that stock prices "may not be as absurd as some people think."
CAPE's Upward Trend
In any case, the CAPE for the S&P 500 has been more or less on an upward curve for a century, and some say that may be warranted.
According to investment manager Rob Arnott, the founder, chair, and CEO of Research Associates, this upward trajectory made sense over a period of time during which the United States progressed from being essentially an emerging market to the world's dominant economy. That alone, he believes, could justify an increasing earnings multiple for U.S. stocks.
The S&P 500 CAPE ratio has been lurching upwards for more than a century. In 1880, it was about 18. At its highest point, in 2000, it approached 45. As of the end of 2020, it was 33.82.
While the current value of CAPE is above its long term trend line, the difference is much smaller than in 1929, as Arnott's detailed research paper shows.
Moreover, reforms imposed in the 1930s such as the creation of the Securities and Exchange Commission (SEC) and the imposition of stricter financial reporting standards, probably helped lift the CAPE by increasing confidence in the U.S. markets. The quality of reported earnings today is arguably much higher than in 1929. Accordingly, the value of CAPE for 1929 may be understated, given that its denominator, reported corporate profits, could be overstated by today's standards.
Finally, there is the fact that CAPE is, after all, a look backward at 10 years of corporate earnings. These days, rightly or wrongly, investors base their choices on their expectations of profits going forward.
The 1929 Crash
Robert Shiller hadn't even been born at the time of the 1929 crash, but we now know that his CAPE ratio would have put stocks at a record level of 30 just before. That was the end of a 10-year bull market that had started out with the market at a ratio of about five. Which is about the level they returned to when the dust settled in 1930.
The Great Crash of 1929 is mostly associated with plummeting stock prices on two consecutive trading days, Black Monday and Black Tuesday, Oct. 28 and 29, 1929, in which the Dow fell 13% and 12%, respectively. But this double-whammy was only the most dramatic episode in a longer-term bear market.
In 1929, economists couldn't point to the soaring CAPE ratio to explain the Great Crash, but the reasons given for it, then and now, were reasonable. Irrational exuberance among investors pushed stock prices to unsustainable levels. They thought the economic boom would never end. The brashest investors went way out on a limb to buy on margin. And, interestingly, interest rates made borrowing cheap, encouraging speculation.
The Great Crash is considered to be one of the factors contributing to the onset of the Great Depression of the 1930s.
'Unintended and Undesirable Consequences'
Concerned about speculation in the stock market, the Federal Reserve responded aggressively by tightening its monetary policies starting in 1928. The Fed apparently thought this would temper the speculation a bit while not doing too much harm to the markets overall. Instead, it may well have contributed to the Great Crash, a modern study by the Fed showed. Worse, the Fed kept money tight after the crash, probably prolonging and intensifying the financial crisis
Moreover, in 1929 the Fed pursued a policy of denying credit to banks that extended loans to stock speculators. Stock market speculation, the Fed concluded, diverted money from productive uses that benefited American industry and commerce.
"Detecting and deflating financial bubbles is difficult," the Fed's history of the 1929 crash concludes. "Using monetary policy to restrain investors' exuberance may have broad, unintended, and undesirable consequences."
Playbook For Limiting Crash Damage
In October 1929, in the aftermath of the worst days of the crash, the Federal Reserve Bank of New York pursued an aggressive policy of injecting liquidity into the major New York banks. This included open market purchases of government securities plus expedited lending to banks at a decreased discount rate.
Their actions were controversial at the time. Both the Federal Reserve's Board of Governors and the presidents of several other regional Federal Reserve Banks claimed that president George L. Harrison of the New York Fed has exceeded his authority.
Nonetheless, this is now the accepted playbook for limiting the damage from stock market crashes, according to the Federal Reserve's history of the crisis.
After the 1987 stock market crash, the Fed under Chair Alan Greenspan moved aggressively to increase liquidity, particularly to bolster securities firms that needed to finance large inventories of securities that they had acquired by filling the avalanche of sell orders from their clients.
The CAPE Ratio and Other Stock Market Crashes
In response to the financial crisis of 2008, the Fed under Chair Ben Bernanke launched an aggressively expansionist monetary policy designed to prop up the financial system, the securities markets, and the broader economy. This strategy, hinging on the purchase of massive quantities of government bonds in order to push interest rates to near zero, is commonly referred to as quantitative easing.
Greenspan, meanwhile, is among those who now warn that, by continuing this easy money policy for years after the 2008 crisis was stemmed, the Fed has created new financial asset bubbles.
Also in response to the 1987 crash, the New York Stock Exchange (NYSE) and the Chicago Mercantile Exchange (CME) instituted so-called circuit breakers that halt trading after a sharp drop in prices. These safeguards are designed to slow a wave of panic selling and help the markets stabilize.
New Era, New Risks
All of the above might lead you to conclude that nothing changes on Wall Street. But that's not entirely the case, for better or worse.
Computer-driven program trading, which caused rapid waves of frenzied selling in 1987 as well as later violent market downdrafts such as the Flash Crash, has increased in speed and pervasiveness. The upshot is that computerized trading algorithms may pose one of the biggest threats to the markets today.
After the experience of 1929, the Fed has been understandably reluctant to tighten monetary policy in an attempt to deflate an asset bubble. However, it is also increasingly concerned about keeping inflation in check. Any miscalculation that raises interest rates too high and too fast could spark a recession and send both stock and bond prices tumbling downwards.
Plus, an increasingly interconnected world economy means that the spark that ignites a stock market plunge in the U.S. can be lit anywhere around the globe.
Stock Market Crash FAQs
Why Did the Stock Market Crash in 2020?
The 2020 market crash is generally known as the Coronavirus Crash, for obvious reasons. From about Feb. 20 through April 7, stock prices pulled back before reentering the bull market and hitting new record heights.
The reasons for the crash are clear: The coronavirus pandemic was and is a global economic crisis as well as a human tragedy. Businesses from international hotel chains to corner delis were decimated. Unemployment rates soared.
The bigger question is, why did the markets recover so quickly? Foreign Policy magazine concludes that Wall Street is on another planet from Main Street. The experts it queried noted that the indices are heavily weighted towards resilient technology stocks. The Federal Reserve has kept lending rates low, making money cheap. Investors are looking ahead to a post-pandemic boom. There are many reasons why, and the reasons why not just didn't resonate on Wall Street.
Will There Be a Stock Market Crash in 2021?
"Nobody knows anything." That classic quote from screenwriter William Goldman summed up the collective ability of Hollywood professionals to guess whether a movie would be a hit or a stinker.
After peaking at a value of 381.17 on Sept. 3, 1929, the Dow eventually would hit bottom on July 8, 1932, at 41.22, for a cumulative loss of 89%. It would take until Nov. 23, 1954–more than 25 years later–for the Dow to regain its pre-crash high.
The same could be said of the financial industry in 2021.
What Are the Causes of a Stock Market Crash?
The causes given for the Great Crash of 1929 have been present in every market crash before and since. Over-enthusiasm among investors pushes stock prices to levels that are detached from reality. The warning signs are ignored. And then, one day, market sentiment changes, and panic ensues.
There's also this basic law of the markets: It moves in cycles that go up and down and up again.
Can You Lose All Your Money in a Stock Market Crash?
You will lose your entire investment in a stock only if the company that issues it goes bankrupt and its stock price drops to zero. You could lose all of your profits and a hefty portion of the principal you invested if you sell the stock immediately after a wide-scale market crash. If you hang onto the stock, it may regain its value and then some.
That said, you could go totally broke by dabbling in riskier strategies like margin buying, which entails borrowing money to buy stock in order to multiply your potential gains (or losses).
What Are Some Warning Signs of a Stock Market Crash?
The reason that Robert Shiller's CAPE Ratio is getting so much attention these days is that it is considered a potential warning signal of a stock market crash. A high number is considered a warning sign that stock prices are too high compared to the actual earnings of the companies they represent. At the end of 2020, the S&P 400 CAPE ratio stood at 33.82, or 33.82 times average earnings for the past 10 years, adjusted for inflation. It hit 28 just before the 2008 market crash.
That's a warning sign, but a sign is not a certainty. Nobody can say definitively when the next downturn in the stock markets will occur.
The Bottom Line
No one time the markets perfectly. That is, it's not possible to predict precisely when a stock, or the markets in general, will hit a low point or a high point.
This never stopped anyone from trying. The S&P 500 CAPE ratio is just one of many ways that investors use to help them judge whether stock prices are justified by their earnings, or whether they're headed for a crash.
Of course, there will be a downturn. When it will happen and whether it qualifies as a crash or a milder decline is an open question. But the cycle of market ups and downs is a fact of life for the investor.
One other thing to keep in mind: You're only guaranteed to lose money in a market crash when you lock in your losses by selling right afterward. That's the nature of the cycle.