Today’s stock rates are so severe that a drop of 40 % -50 % would not be a surprise.
Indeed, it would take a drop of this magnitude just to get back to typical long-lasting valuation levels, let alone cheap.
Meanwhile, after 5 years of anxiously pumping cash into the financial system, the Fed is not only still going full bore (interest rates are zero) however facing ever-increasing pressure to alleviate off the gas.
So if stock rates do drop dramatically, it doesn’t promise that the Fed will be able to do much to help.
Meanwhile, business profit margins are still at all-time highs, earnings are still at lowest levels, and average American consumers still have financial obligation coming out of their ears.
So it promises that, at some time, profit margins will decrease, earnings will increase (we can only hope), and average American consumers will certainly continue to check spending– none which will improve additional earnings growth.
Meanwhile, interest rates are still at lowest levels. So if and when the economy does finally gather a sustainable head of steam, rate of interest will likely rise. And increasing rate of interest do not have the tendency to be handy to equip prices.
So that’s one circumstance for stock rates over the next several years:
- Stock rates go back toward lasting averages
- The Fed eases off the gas
- Corporate profit margins revert toward their long-term averages (ideally due to the fact that companies finally begin to share some of the wealth they develop with the people who create it)
- Consumers continue to save cash and work off debt
- Interest rates rise
If any of those things occur, stock performance will likely be inadequate for many years.
But that’s not the catastrophe situation. That in fact appears like a perfectly affordable scenario.
The catastrophe circumstance is that some or all these measures do not simply go back toward their long-lasting averages but rather go back beyond their long-lasting averages– the means they usually have before.
If we go from a period with marvelously high stock costs, marvelously low interest rates, marvelously high earnings margins, and spectacularly stimulative Fed policy to an era defined by the opposite (like the 1970s), the sharp crashes and fairly fast recuperations of 2000 and 2008 will seem like quick, happy corrections.
It took about 25 years for the economy and market to correct the extremes of the 1920s. It took another 25 years to fully work off the (much lower) extremes of the 1960s.
The extremes of the late 1990s, which have extended into the 2000s and, now, the 2010s, are, by some measures, the most severe in history (consisting of the 1920s).
It needs to not come as a surprise, therefore, if it takes us as long, if not longer, to work them off.
Stock prices are extremely pricey. Today’s cyclically-adjusted P/E ratio is the greatest price-earnings ratio in 135 years, with the brief and short-term exceptions of 1929 and 2000. Rate of interest, on the other hand (red line), are generally as low as they can go.
Corporate revenue margins are at all-time highs, helping to support today’s stock rates. Keep in mind how revenue margins normally revert to (and beyond) the mean:
The extremes of the 1920s and 1960s took decades to work off. The black line below programs the inflation-adjusted S&P 500 rate for the past 130 years. Note the 25 years in between the 1929 peak and the next sustained rise, as well as the 25 years after the 1960s peak. We have to do with 14 years into our current work-out period– from valuation extremes that were much greater than in the 1920s and 1960s. It would not be surprising if we had another decade or more of work-out to go.