Are we heading for a big stockmarket crash?

The stockmarket crash of October 1987 is infamous for its speed and scale. On Monday 19 October – hot on the heels of a tough week – the Dow Jones index plunged by more than 20% in a single trading session. Markets around the globe were hit hard too – over the course of the crash, the New Zealand market lost 60%, for example. In the end, the crash caused little lasting damage. Markets recovered quickly and the economy saw very little impact. Even so, we’d all rather sit a 20% market loss out, if at all possible. So is there any way to predict when such a plunge is likely?

A few people did see the crash coming. One was Martin Zweig, a successful academic, newsletter writer and fund manager. He warned the Friday before “Black Monday” to expect a crash. And unlike others who forecast the crash (such as Elliott Wave analyst Robert Prechter and financial analyst Elaine Garzarelli), Zweig was no one-hit wonder. He had a strong track record both before and after the crash. Zweig died in 2013, but now, as Algy Hall says in Investors Chronicle, his model – which warned investors to sell a month before the 1987 crash – last month issued its first “sell” warning in ten years.

So does a re-run of 1987 lie ahead? As Hall points out, there are some eerie parallels. Markets are highly valued (1987 saw “gross overvaluation in p/es [price/earnings ratios] and yields”, as Zweig put it). We’ve gone a long time without a significant correction (though not as long as in 1987). Critically, the Federal Reserve is starting to tighten monetary policy, albeit extremely gradually – Zweig felt that monetary policy drove share prices more than perhaps any other variable. And his model has a pretty good record. It warned investors to sell in September 1999, not long before the tech bubble burst, and it came close to warning them to get out in late 2007, although it didn’t issue an unambiguous “sell”.

But the real problem is: “what can you do about it?” There is no foolproof method for predicting crashes, and if you moved all your money into cash right away, you might end up kicking yourself in a year’s time. Various measures have flagged the US stockmarket as grossly overvalued for years (see below), but it has stubbornly kept rising. You shouldn’t ignore overvaluation or “sell” signals. But attempting to trade in and out of the market based on them is a surefire way to end up losing money. Rather than fret about the prospect of a rapid ‘87-style correction, it may be better to take the advice of Oaktree Capital’s Howard Marks: given the fact that markets are strikingly overvalued today, “reduce risk to prepare for a correction” and during that period “accept still-lower returns”.

How overvalued is the US stockmarket?

One of the most commonly used market valuation measures is the Shiller price/earnings ratio (also known as the Cape, or cyclically adjusted p/e). This looks at the price of the market compared to earnings averaged over ten years (which irons out fluctuations due to the business cycle). The S&P 500 is currently on a Cape of just over 30. That’s higher than at any point in history (including prior to the 1929 and 2008 crashes) except for the tech bubble, when the Cape peaked at 44.

What about other measures? Economist Andrew Smithers keeps a close eye on Tobin’s Q, which compares the market value of the companies in an index with their book value. The basic idea is that if it would be more expensive to buy all the companies in the index rather than setting them up from scratch, then the market is overvalued. On this measure, reckons Smithers, the US market is overvalued by about 70% – less expensive than in 1929 and 2000, but expensive nonetheless.

Alternatively, there’s a measure that Warren Buffett claimed to follow in 2001 – market capitalisation versus GNP. The idea is that corporate profits are ultimately a function of economic growth, so stock prices should broadly reflect the size of the economy. On this measure, the market is more overvalued than at any time other than 2000. None of these measures is perfect, and you certainly can’t use them to time the market – they’ve all registered the US market as being overvalued for several years now. But as analyst Jesse Felder put it in a blog earlier this year: “if you believe that ‘the price you pay determines your rate of return’ then at current prices you must believe we currently face some of the worst prospective returns in history.

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