Stock Market Bubbles In Perspective (Or Why "This Won't End Well")

Authored by Howard Ma via Meritocracy Capital,

Last week marked the 9th anniversary of the collapse of Lehman Brothers. It was one of the biggest milestones of the Global Financial Crisis (“GFC”) that began approximately a year earlier in 2007. Corporate earnings were abnormally weak during the GFC. I bring that up because a much cited stock market valuation metric that has been prescient gauging past bubbles could be overstated due to those abnormally weak earnings. Those of you concerned about the valuation of the U.S. stock market should read on.

What Does Average Mean?

The cyclically-adjusted price-to-earnings (“CAPE”) ratio is normally credited to Nobel-prize winning economist Robert J. Shiller. It adjusts for the ups and downs of business cycles by comparing the price of the S&P Composite Index to the average, annual inflation-adjusted earnings of that index over the previous 10 years. There are three types of averages: mean, median and mode. The type of average the CAPE ratio uses is the mean (a.k.a. arithmetic mean). Though the CAPE ratio has been shown to be a reliable predictor of future long-term stock market returns, it has also been widely criticized.

One criticism is that the CAPE ratio is susceptible to outliers. For example, those abnormally weak earnings that occurred during the GFC drag the mean, annual inflation-adjusted earnings down. This could make the CAPE ratio of the S&P Composite Index look more expensive than it may actually be. It has been widely reported that the CAPE ratio is currently at a very high level behind only two other stock market peaks: 1) the Tech Bubble, and 2) the stock market bubble that occurred during the Roaring Twenties (immediately preceding the Great Depression). In both cases, the stock market eventually crashed and in spectacular fashion.

One way to adjust for this problem of abnormally weak earnings is to instead use the peak earnings of the past decade. This approach has been credited to investment manager John Hussman. Ironically, the lesser known Hussman P/E currently shows that the S&P Composite Index is at a very expensive level second to only the Tech Bubble. Those who argue the U.S. stock market is not expensive don’t care for this approach.

Using a Better Average

I agree that using an arithmetic mean makes the CAPE susceptible to outliers. I also agree the CAPE ratio can also make the valuation of the S&P Composite (or any stock market index) look more expensive than it may actually be. Though I believe the Hussman P/E is useful, I don’t believe it is a substitute to the CAPE ratio. An average measures a central or typical value. Using a peak figure, as in the case of the Hussman P/E, does not do this. By using peak earnings, the Hussman P/E is in fact driven by outliers.

Mentioned earlier, there are three types of averages. A better type of average would be the median. It literally represents the middle of a sequence of ranked numbers. In most cases, it is not influenced by outliers. By using median (instead of mean) earnings, I refer to this valuation approach as the CAPME ratio. It currently shows the S&P Composite is not the second or third most expensive stock market cycle. This finding supports those who criticize the traditional CAPE ratio of overstating the valuation of the S&P Composite Index. The problem for critics though is using the CAPME ratio still shows the U.S. stock market is very expensive right now. In fact, it is the fourth most expensive, behind the stock market cycle that occurred during the Subprime Mortgage Bubble. Based on the data Professor Shiller uses, you can see this in the graph below that looks back 135 years.

Valuations in Perspective

You will notice in the graph above that the past 5 stock market bubbles were all valued at one point at more than 20-times median, annual, inflation-adjusted earnings. The valuation range of those peaks is wide though given the Tech Bubble was valued at more than 40-times at its peak.  This makes the Tech Bubble potentially an outlier. Furthermore, all 5 stock market bubbles did not last long. They were fleeting.

To put this all into perspective, consider these valuations by their percentile ranks. You can see this from the orange lines in the graph below.

The graph above shows the aforementioned 5 stock market cycles turned into bubbles when their CAPME valuation ratios reached a very high level of roughly the 90th percentile (red dotted line). In other words, these bubbles formed when their valuations were near or at the most expensive decile. Investors beware: the valuation of the S&P Composite Index is currently ranked at the 94th percentile.

This puts the U.S. stock market smack-dab at the heart of bubble territory.

It has been argued lots that the high stock market valuation is justified by low interest rates. This argument does not work for me. Let me tell you why. Yields on 10-year U.S. treasury bonds in early-1941 were lower than they are now. Despite lower interest rates in early-1941, the stock market CAPME valuation ratio was quite low at that time ranking at around the 30th percentile. Furthermore, the amount of debt provided by stock brokers used to fuel the current stock market cycle is at a record level. This could prove problematic given bubbles driven by financial leverage are particularly dangerous.


The aforementioned 5 stock market cycles turned into bubbles when their CAPME valuation ratios reached the 90th percentile. The U.S. stock market is back there again. Its valuation is squarely in the middle of that very expensive decile looking back 135 years.

The 5 previous instances of stock market bubbles suggest this will not end well. Bubbles never do, particularly ones driven by financial leverage.


Snaffew Thu, 09/21/2017 - 11:33 Permalink

none of the previous bubbles were supported by unrelenting and massive QE and money printing.  The current bubble is wildly unique as compared to all other bubbles....the eps of the companies used for calculations have all been able to borrow money at ZIRP and use that to perform stock buybacks, therefore, artificially inflating real earnings.  This factor alone tells of a wildly overvalued market, perhaps the highest in history, but that does not mean it is destined to fail immediately, it just means that the current environment is able to disguise the madness even better than all previous historical peaks have.  Someday, this will end---but trying to tiime it without a meaningful breakdown in the moving averages seems foolish to me.

Gorgeous Thu, 09/21/2017 - 11:41 Permalink

Didn't some contributor recently show how awash the system is in liquidity after the global CB cartel has taken their merry turn giving banks, and thus corporations, free cash to buy back their stocks?  Oh, and also that the CBs themselves are buying assets?When someone overlays the asset "bubble" chart with corporate stock buy-back,  CB asset holdings, and money supply charts, I'll pay more attention. In the mean time, carry on with these average articles, according to your current mode of operations.

Consuelo Thu, 09/21/2017 - 11:39 Permalink

  Depending on what metrics one chooses to use (infinite possibilities...?), the current 'bubble' can be interpreted as:- Nothing- Normal- Medium-sized- Toppy- Out-sized- Biggest in history What the bloody hell does it matter any more.   Just make sure you have the sustenance to pull through it when the floorboards start to give.

innertrader Thu, 09/21/2017 - 12:42 Permalink

I've only been reading on here how it's "not going to end well" for the last 6 years and it's only doubled since then.  If you count the earnings, it's tripled, if you reinvested the earnings, it's quadrupled!  Gee, do you think they will be right some day, from some point? If so, will it still be best to keep reinvesting???  Just asking, cause I sure as heck don't know!SETH RICH???TRIUMPH with TRUMP!!!

Richard640 Thu, 09/21/2017 - 12:51 Permalink

The end is nigh, brother, the end is nigh!  World markets are like a pie crust stretched across the roof of a volcano! Fu Manchu is about to pull the lever to the trap door! Warbucks signals the trusty  Punjab to cut the cords of the rope bridge!  Grease the skids! Happy tobogganing!

Richard640 Thu, 09/21/2017 - 12:52 Permalink

The end is nigh, brother, the end is nigh!  World markets are like a pie crust stretched across the roof of a volcano! Fu Manchu is about to pull the lever to the trap door! Warbucks signals the trusty  Punjab to cut the cords of the rope bridge!  Grease the skids! Happy tobogganing!

yerfej Thu, 09/21/2017 - 13:10 Permalink

Compare upside "potential" to the massive downside risk. I can't see staying in the market right now as if it does implode (I think it will) I will not be able to retire. BUT to lose out on the limited upside? Doesn't mean anything.

Rebelrebel7 Thu, 09/21/2017 - 15:37 Permalink

But what does NBC ( NoBody's Cultue) or CNBC  ( Clearly NoBody's Consultant) have to say regarding this matter?! Rebelrebel7

Personal information

Turn on ( your device ), Drop In , and Zero In! is your life America!Watch "Maurice Ravel Bolero London Symphony Orchestra Valery Gergiev" on YouTube "Imagine Dragons - Radioactive" on YouTube "PIL - Public Image" on YouTube interest is The 8th wonder of the world- those who understand it earn it, and those who do not pay it.- Albert EinsteinIf America has a capitalistic economy, we must really suck at creating capital with a $21 trillion national debt and $500 billion trade deficit in 2016! Where is the capital?!Life under The Federal Reserve Act of 1913:Watch "HELTER SKELTER THE BEATLES NO COVER VIDEO ORIGINAL" on YouTube up and drink the coffee! Smelling it doesn't work!This is not capitalism! This is Mussolini style debt financed militaristic bankism!Lying about history and reality does not change history or reality, it only changes the person who is lying , and for the worst! Hillary Clinton is a walking example of this!Congress must be charged and held accountable for power crimes! All laws which they have passed in violation of the Bill of Rights and laws exempting themselves from accountability!The central banking third-way, triangulation strategy of the neocons and neoliberals,  is to unite the country ( and the world ) around perpetual war, the anhialation of the Bill of Rights and the constitution, globalist free-trade policies in a race to the bottom, pitting US workers against those earning $2 a day, through a  central banking debt financed money supply which enslaves virtually everyone in the world with only a few notable exceptions, North Korea and Venezuela who have rejected privately owned Central banks!  The false flag against communism and socialism is nothing more than that, with communist China and socialist EU countries to varying degrees as proof! We must do the opposite! We outnumber them on a scale of 1,000 / 1!Unite the sane and independent center! Commit to not choosing sides in the neoconservative / neoliberal civil war !Don't take it to the streets! Take it to the internet! Legislation has never been changed as a result of people protesting with signs!Let the pen and the truth be your deadliest weapons against the corrupt, war-mongering, psychopathic establishment!Watch "Pink Floyd - Another Brick In The Wall (HQ)" on YouTube't be a useful idiot that elevates the establishment's two party system!Both parties have destroyed the Bill of Rights and both parties are war mongering treasonous tyrrants!This strategy could destroy the two parties which have  destroyed America!Americans should unite around issues that we can all agree upon. These issues are all ignored by the establishment elites of the neocons and neoliberals.1.We must repeal the Federal Reserve Act of 1913 and abolish the Federal Reserve. Congress must resume its responsibility and coin money and regulate its value as granted to Congress in Article 1 Section 8 Clause 5 of the constitution.The fundamental flaw in main stream economics is that it begins by accepting  the validity of the Federal Reserve Act of 1913, the IMF, BIS,  and World Bank which are all part of the privately owned banking cartel charging interest to sovereign nations which is nothing more than a bank tax on citizens for which they have no right to claim, therefore making it a circular argument based on a logical fallacy!If we continue down the yellow brick road of the Federal Reserve Act of 1913 and privately owned international central banking cartel:1.)We will destroy the economy  when we  reduce the national debt,  because the money supply is based on debt.2.) There will  be an endless boom bust cycle because when the banks issue loans, they create money in the equivalent of the principal of the loan, but do not create the money required to pay the interest on the loan, leaving a shortfall in the money supply of the interest payments required.3.) We will go deeper into debt or destroy the economy because the only central bank solutions are  to issue more debt or destroy the economy.If Congress were to resume its responsibility as stipulated in Article 1 Section 8 Clause 5 of the constitution and coin money and regulate its value debt free, and if other nations would do the same:1,) The budget would automatically balance.2.) There would be no need for income taxes, estate taxes, capital gains taxes, and corporate taxes.3.) There would be no need to reduce spending.The rise of cryptocurrencies has litigated and won the case before the world, precisely how easy it is to get rid of the central banks! I prefer cash, which would not use the gold standard because history has proven that every time that it has been implemented,  most of it ends up in the hands of a few wealthy families, and it and they destroy the nation!During the middle ages in England, King Henry 1st implemented the tally system and the bankers and goldsmiths did not control the economy, the average man provided everything necessary for his family by working 16 weeks a year! The rest of the time was spent learning, traveling,  on the arts, and volunteering for the church! For more on this topic please read The Web of Debt and the Shocking Truth About Our Money System And How We Can Break Free by Ellen Hodgson Brown J.D.2.The military should be used for defending our borders. We should close the 698 permanent foreign military bases and 400 temporary military bases. Our international meddling is jeopardizing national and international security, human life, and economic prosperity. We should retract from all war on foreign soil.Watch "Rage Against The Machine - Bulls on Parade" on YouTube The prison industrial complex and the war on drugs must end. It is a horrific human rights abuse and is completely unacceptable.4. All laws which violate the Bill of Rights must be immediately repealed. The NDAA, The Patriot Act, HR6393, The American Freedom Act are all grotesque unconstitutional violations of the 4th amendment.  5. Freedom of speech and of the press , and  the right to assemble, must be protected. The government has removed the common thread that wove the fabric of our nation, our liberty, in a futile attempt to take the heat off of them, where it rightfully belongs, and to incite civil war, leaving corruption as usual in charge!* * * * * * * * * * * * * * * * * * *What's up Doc?!Medical spending accounts for 18% of GDP, 12 % of GDP spending is totally wasted in a medical establishment free for all that is killing tens of thousands of Americans each year!Everyone knows that the medical community is first and foremost and also for most, a snake venom racket that profiteers off of the misfortunes of others!2/3 of prescription drug spending is spent on psychiatric drugs ! Not only have they been proven not to work,  they make the underlying psychiatric ailment worse, and also cause extremely dangerous and costly health problems! 20% of patients use 80 % of the medical benefits! These drugs have been proven to  lead to obesity, diabetes,  heart disease, chronic pain,  and many other severe and frequently life threatening health risks such as the potentially fatal neuroleptic malignant syndrome. Atypical antipsychotics have also been proven to increase obsessive compulsive behavior including compulsive gambling and substance abuse. There is currently a class action lawsuit against Abilify for this! "Suicidal Tendencies - "Institutionalized" Frontier Records" on YouTube is zero incentive for anyone in America to discuss this because they are all making trillions off of it!Under stress, the brain activates the fight or flight response. Since we live in a fascist society which has the worst human rights abuse record on the planet, the majority of people opt for mental flight. They stay where they are, but mentally check out through the use of drugs and alcohol!All treatment centers rely on 12 step programs that have a 6% success rate, effectively showing a 0% success rate since 5% simply quit on their own without treatment, this is a  statistically insignificant increase in recovery success in contrast to no treatment. These programs have high suicide rates and add to the increased depression and alienation of those who question the "wisdom " of Bill Wilson!Since treatment centers make $12,000 to $50,000 for treatment, they are highly content with the revolving door policy of alcoholics and addicts relapsing and returning!The problem with 12 step recovery programs is that they are fascist in nature, increasing the fight or flight response and subsequently,  relapse.The 12 steps in and of themselves are excellent, but the Big Book which members place above the bible is completely insane and new comers whose lives have been turned into shambles are told that everything is exactly as God intended it. If that is the case, I guess that if they drink or use drugs, that is God's intention,  so why even bother going to AA? The newcomers  are also mentally assaulted if they reject the flawed ideology. They say the serenity prayer, but only believe that they are supposed to accept all of the injustices of the world and have been brainwashed into believing that they cannot change people, places, or things. If you have ever cleaned a house, or have done any gardening,  you know that is a lie! If you have ever had a discussion with someone, and either your own mind, or theirs was changed as a result of the information exchanged,  you know that is a lie! If you have ever read anything, or written anything and had your own mind changed by what you have read, or changed someone elses mind by what you have written, you know that is a lie! They expect you to have a sponsor who has ruined their own life, micro-manage yours!They say that politics cannot be discussed, even though the 12 traditions only say that the GROUP  does not endorse or oppose any causes! All issues are political. It is not merely talk of individual politicians that they forbid, they prefer a world view that blocks out everything except their own connection to it, essentially denying the existence and reality of almost the entire world. It is my hope that treatment centers, 12 step program central offices and groups will do a serious 4th step so that they are no longer exacerbating the situation in light of this national crisis!Watch "Neil Young - Needle and the Damage Done" on YouTube* * * * * * * * * * * * * * * * * *Profiteering drug dealers AKA big pharma prevent the cost effective, medically effective alternative of marijuana, CBD and THC preferring to charge people $475,000 to treat cancer! "More recently, scientists reported that THC and other cannabinoids such as CBD slow growth and/or cause death in certain types of cancer cells growing in lab dishes. Some animal studies also suggest certain cannabinoids may slow growth and reduce spread of some forms of cancer. There have been some early clinical trials of cannabinoids in treating cancer in humans and more studies are planned. While the studies so far have shown that cannabinoids can be safe in treating cancer, they do not show that they help control or cure the disease." is also a far more potent analgesic than opioids and it is not physically addictive!We feel your pain in our wallets! Love the AMA and pharmaceutical industry!CBD and THC have also proven to be more effective at reducing anxiety disorders,PTSD, ADHD,as well as depression and other psychiatric disorders!From the Journal of Neuropsychopharmcology:* * * * * * * * * * * * * * * * * * *Thank you to the hackers, stalkers, thieves, spies, and vandals, who have made me realize precisely how poweful my message is. You have instilled a self confidence that I have never had. You wouldn't be expending all of this energy to silence and isolate me if I was as insignificant as you would like me to believe. Enjoy your pyrrhic victory, as I spend the rest of my life carrying my message to hundreds of thousands of people while destroying your pathetic lives, One. Second. At. A. Time.To any other victims of the American terrorism industry, please publicly thank them on social media. Companies will stop hiring them when they realize how innefective, stupid, and incompetent they are. Please also post the link below.I've been through a hell of a lot worse than this in my life. If it is anything short of a mushroom cloud, you will not intimidate me.The very fact that they are such cowards that they are afraid to communicate directly is solid proof that they are whimps that should be laughed at, and not feared!The intellectually and morally impaired surveillance industry has been surveilling innocent people and selling information on them for profit to other intellectually and morally impaired genetic mutants! They and the people that they sell it to are monsters!What you thought was tinnitus, is probably a 1 nanometer 2 way transistor radio implanted by a doctor without your consent! Watch "Iggy Pop - Lust For Life" on YouTube "Echoes" on YouTube did this happen?!Watch "The Beatles - Live and Let Die" on YouTube "Suicidal Tendencies - You Can't Bring Me Down" on YouTube "R.E.M. - It's The End Of The World" on YouTube