Will the Stock Market Crash?

It's a questions that I hear a lot these days and in this article I will explain how we value investors look at the stock market overall. Though we primarily focus on individual businesses it is a good idea to follow some of the important macro trends.

Value Investor Howard Marks of Oaktree Capital Management writes that the stock market swings like a pendulum: from euphoria to depression. But how can we know where the pendulum is at right now?

To answer these questions the “Buffett indicator” can help. In an interview in 2001 Buffett said that the stock market capitalization-to-GDP ratio as “the best single measure of where valuations stand at any given moment.” Let’s translate that into plain English...

Buffett says there’s a relationship between the stock market value and the health of the American economy – GDP. If GDP is going up, the stock market is likely to go up. In the perfect world, the stock market and GDP should move proportionately.

The “Buffett Indicator” tracks the market capitalization of the Wilshire 5000 Market Index compared to the GDP of USA. Market capitalization (also known as market cap) of a business is the number of their stocks multiplied by the current stock price. The Wilshire 5000 Market Index is the broadest stock index of American companies. GDP is Gross Domestic Product. Simplified it’s the total production of the US economy - the money spent by consumers, businesses, and government.

Warren Buffett mentioned that over 1: stocks are expensive. In the latest reading (Q2 2021) the Buffett Indicator is at 2.45.

If we use the Buffett Indicator as a pendulum the answer to where the pendulum is right now is Euphoria in the stock market.

When is the right time to buy on the course of the pendulum? According to Phil Town: When Wilshire is 70% of GDP (0,7 on the graph) it’s a pretty good time to buy stocks. But when it reaches over 100%, the market becomes overpriced. It’s a fundamental indicator (real money, real earnings).

Is it safe to buy stocks in an overvalued and euphoric market as we have today?

The answer is NO! it’s risky. It’s risky because if you buy at the top, there’s a long way back up when the market crashes.

At a 50% loss you’ll have to gain 100% to break even. So, what should you do? First of all: there’s always undervalued stocks. Stocks that aren’t trendy or with companies where there’s a temporary problem. With education you can find those undervalued stocks and without a high IQ, but with common sense analyse if an undervalued company has a temporary problem or is a super bad investment. Or you can spend the time right now finding wonderful businesses so when the time come, you’re ready for the sale and know what price to buy your wonderful business at (I teach that in my course).

"Every once in a while, an up-or-down-leg goes on for a long time and/or to a great extreme and people start to say, "this time it's different." They cite the changes in geopolitics, institutions, technology, or behaviour that have rendered the "old rules" obsolete. They make investment decisions that extrapolate the recent trend. And then it turns out that the old rules still apply and the cycle resumes. In the end, trees don't grow to the sky, and few things go to zero."

Howard Marks

Will the market crash?

This is an impossible question to answer. Will it crash – most likely at some point. But when and how to guess that would happen it pure speculation. Neither Warren Buffett nor I engage in this type of predictions.

There is one indicator that when we look at it we can see a correlation between the rate and the instability of market. This doesn’t answer when it will happen but simply indicate what has happened in the past. It’s called the Shiller P/E.

Robert Shiller is a Professor of Economics at Yale University.

P/E is “price to earnings” – a company stock’s current price divided by the company’s actual earnings (per share). A company’s earnings are the after-tax profits.

The current P/E ratio of a publicly traded company is easy to find on Yahoo Finance.

According to the Shiller P/E the average P/E ratio of the S&P500 for the past 100 years is 16.

The S&P500 is the 500 largest public companies is USA - largest by market cap. A reasonable price to pay for a company is a price that equals a P/E of 16. The P/E helps investors determine the stock market price vs. the company’s actual value per share (simplified). So, if the P/E is high you’re paying a high price for your wonderful company.

In my free investing checklist, you find out how to use P/E to find a great price for the stock in your wonderful company.

The Shiller P/E averages off the S&P500 P/E for 10 years and it’s adjusted for inflation over time. It’s called a cyclically adjusted PE ratio. According to the Shiller P/E the current P/E ratio of the stock market is 38 which means that the market is overvalued. The first time the P/E was above 30 was in 1929 and next time in 2000 - the third time is now. So, it’s only been this high 2 times before in the last 100 years and what happened the other two times was that the stock market crashed. 2000 is known as the it-bubble and 1929 as The Big Crash. And then the third time is right now.

And on a last note: Just because the stock market might eventually crash, a crash doesn’t mean that companies become worth less over night. Some companies are not impacted by market swings (some companies are - depending on the event and other factors). For a value investor a correction in the market is an opportunity. First, we calculate the price of the business and then we adjust our buying price, so we get the stock on sale. We call that buying with an error margin or “margin of safety”. I teach that in my investing workshop.