How Low Will Stock Prices Go Following The Next Price Crash?

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by: ValueWalk
Summary

Shiller's claim that it is irrational exuberance that sets stock prices in bull markets contains a troubling suggestion.

We can never appreciate the instability of stock prices set by emotion at the time that we are living through them.

It is human nature to want to tune out the possibility that we will ever again see a CAPE of 8.

Original post

By Rob Bennett

Today's CAPE ratio is 31. We are in the last days of the fourth bull/bear cycle that we have experienced since 1870 (that's as far back as we have good records of stock prices). The three earlier bull/bear cycles did not come to an end until the CAPE ratio approached 8. We took a trip to that CAPE neighborhood in 1877, 1933 and 1982. If we were to drop all the way down to 8 this time, stock investors would be looking at losses of something in excess of 70 percent.

Yikes!

Are losses of that size even remotely possible?

I certainly hope not. I certainly pray not.

And there are good arguments that can be advanced for why we might not drop so low this time.

One is that the historical record available to us is not very large. We have three complete bull/bear cycles and one nearly complete bull/bear cycle. It could be just coincidence that we came close to 8 in each of the three existing cycles and that it is entirely possible for a bull/beat cycle to come to completion without the CAPE ratio ever dropping that low.

However, it does seem reasonable to me to believe that the fact that we have hit 8 at the end of all three earlier cycles suggests that we are likely going to hit at least something in the general vicinity of 8 this time too. Perhaps prices will stop dropping once we hit a CAPE ratio of 10. Perhaps we will only go down to 12. But a drop from 30 to 12 or 10 is still a very scary drop. A drop to 10 would signify a loss of two-thirds of portfolio value for stock investors. That's a very hard hit.

Another possibility is that the economy has changed in some way so that drops that low are no longer required for the irrational depression that always follows a time of irrational exuberance to exhaust itself. Perhaps our policymakers are more knowledgeable about how the economy works today and they will be better able to manage a soft landing this time. Perhaps today's investors are a less panicky bunch.

Perhaps, perhaps.

Do we really believe that? I have been writing on the internet about Shiller's research for 17 years now and I have seen no evidence that today's investors possess more emotional balance than did investors from earlier times. I wasn't on the scene in those earlier days. But I have seen a lot of emotion evidenced by Buy-and-Holders in response to my writings on Shiller's research. If investors of earlier days were even more emotional, please do not ever put me in a time machine and send me back to experience those days. I don't think that I could take it.

Shiller's claim that it is irrational exuberance that sets stock prices in bull markets contains a troubling suggestion. We can never appreciate the instability of stock prices set by emotion at the time that we are living through them. If stock prices really are set by emotion, the emotional creatures doing the price setting are not going to be capable of seeing what they have done. It is in the nature of an emotional phenomena that the rational mind cannot grasp it. Reason and emotion proceed on different mental tracks, they speak different languages.

Ask investors if they believe that we will see a price crash within the next year or two or three and most will acknowledge the possibility. But how large of a price crash is it that most of us anticipate? Just about all of us can imagine a price crash of 20 percent. There are some of a more pessimistic frame of mind who might see a possibility of a price drop of as much as 30 percent. But 40 percent? I don't think that there are too many stock investors who anticipate a price drop of 40 percent. 50 percent? That sounds extreme. 60 percent? All but unthinkable. 70 percent? Not just unthinkable but unspeakable too.

And yet here I am speaking about it.

The thing that I love about looking at the historical stock return data is that it tells me things about how stock investing works that the bravest and smartest humans will not tell me. There is no one predicting a 70 percent crash. But the historical data suggests that it is a possibility. I hate the idea. A 70 percent price drop would have devastating economic consequences. So, like the other humans, I don't even want to entertain the possibility that what we have seen happen in the past could happen once again. But, if there is even a small chance that it could happen once again, I see it as a good idea for us all to think through how best to respond to the event. So I am grateful that the historical return data does not permit itself to be cowed into silence about the dark possibilities that can follow from years of irrational exuberance.

Do I really think that we will see a CAPE ratio of 8? I do not. I believe that smart people will develop ways to assure frightened investors before things get that bad. But I do believe that a drop well below the median CAPE value of 16 is likely. I could certainly see a drop to a CAPE value of 12. And even that is a drop of more than 60 percent. It's a good idea to prepare for worst-case scenarios and the historical return data does a better job of pointing those out than do the human experts who worry about whether what they say will shock their fellow humans.

The thing that I believe people miss about looking at the historical data is that taking its message into consideration helps diminish the possibility that we will be seeing those worst-case scenarios play out on our computer screens. CAPE values of 8 do not pop up at random times. We see them only in the wake of runaway bull markets. It is high stock prices - which numb investors to the obvious reality that prices always return to low levels eventually - that cause the scariest of price drops. It is human nature to want to tune out the possibility that we will ever again see a CAPE of 8. But it is that tuning out process that makes the next appearance of a CAPE value of 8 a live possibility. A community of investors concerned about the implications of CAPE values above 20 would never see a CAPE value of 8 because they would never permit stock prices to rise to the levels that bring on that sorrowful result.

We are unfortunately not that community of investors. Not yet, in any event.

Disclosure: None.

Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.