After Wall Street’s spectacular meltdown last week, Nobel laureate Robert Shiller is ready to forecast a full-blown stock market crash. Although second-quarter gross domestic product (GDP) growth was revised up from 2.3% to 3.3%, equities are chronically overvalued and need a massive sell-off before they fall in line with reality. (Source: The Wall Street Journal, August 27, 2015.)
The panic began on Monday, August 17th, when the S&P 500 was hovering at the 2,100 level. The index lost more than 10% during the week, feeding off fear from China’s stock market crash. All hell broke loose the following Monday when we saw markets open five percent down before gyrating violently throughout the day. The sell-off was contained as quickly as the selling began, with many investors arguing the worst had passed.
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But the most widely respected financial economist in the world thinks they’re wrong.
Robert Shiller Says S&P 500 Could Fall to 1,300
Robert Shiller is the Yale economist who invented the cyclically adjusted price earnings ratio (CAPE), a key indicator for stock market crashes. His work has deeply altered our understanding of financial markets by shedding light on patterns of human behaviour and how they can misdirect capital flows. On Thursday, Shiller published an op-ed in The New York Times that sounded alarm bells across the industry.
“It is entirely plausible that the shaking of investor complacency in recent days will, despite intermittent rebounds, take the market down significantly,” wrote Shiller. “This would put the S&P closer to 1,300 from around 1,900 on Wednesday, and the Dow at 11,000 from around 16,000.” (Source: NYT – The Upshot, August 27, 2015.)
According to Shiller’s CAPE ratio, the stock market is significantly overvalued. The metric modifies historical price-earnings ratios to account for business cycles. Between 1881 and 2015, CAPE averaged a ratio of 17, well below today’s reading of 27. Without singing my own praises too much, let me just say I called this.
There simply wasn’t enough fundamental growth to justify 21% growth in the S&P 500 over the last two years. When you work at the intersection of news and capital markets, you begin to see how herd mentality works. Investors get drunk on optimism and pessimism in equal measure, but the only commonality is that no one wants to be last.
When a sell-off begins, no investor wants to be the last one holding the bag. That’s why, on days like Monday, we saw a huge pullback. Everyone who hadn’t sold on the previous Friday was scared of getting left behind. The same is true in reverse; bull markets are built less on fundamentals than on a collective sense of euphoria.
Robert Shiller: Price Drops Make People Fearful
We’ve been living in an optimism-fueled bull market for the past several years, helped along by “easy money” policies from the Federal Reserve. This stock market correction was a tipping point that awakened many investors to reality. “When prices make a sudden drop, as they did in recent days, people tend to become fearful,” says Shiller. “Some are driven to sell immediately. Others are slower, but they are all similarly motivated.”
Markets were so volatile this week that the New York Stock Exchange invoked an obscure provision known as Rule 48. We saw crash-like declines in the S&P 500 and the Dow Jones, and the exchanges had to at least appear proactive. The clause helps provide a smoother entry to trading when there’s excessive turmoil and the NYSE used it for three consecutive days. (Source: New York Stock Exchange, last accessed August 27, 2015.)
These are highly irregular events, but just days later, Wall Street would like to pretend as if nothing really happened. The market rebalanced fairly quickly as strong buying activity tried to quell the panic, but you can’t just close Pandora’s Box because things are getting rough. There are consequences. What scares me is that herd mentality runs in both directions, so the next sell-off is unlikely to be a calm correction. The longer we procrastinate, the steeper the fall.