Shiller Warns Against Complacency: "Today's Market Looks Like It Did At The Peaks Before Last 13 Bear Markets"

Authored by Robert Shiller via,

The US stock market today looks a lot like it did at the peak before all 13 previous price collapses. That doesn't mean that a bear market is imminent, but it does amount to a stark warning against complacency.

The U.S. stock market today is characterized by a seemingly unusual combination of very high valuations, following a period of strong earnings growth, and very low volatility.

What do these ostensibly conflicting messages imply about the likelihood that the United States is headed toward a bear market in stocks?

To answer that question, we must look to past bear markets. And that requires us to define precisely what a bear market entails. The media nowadays delineate a “classic” or “traditional” bear market as a 20% decline in stock prices.

That definition does not appear in any media outlet before the 1990s, and there has been no indication of who established it. It may be rooted in the experience of Oct. 19, 1987, when the stock market dropped by just over 20% in a single day. Attempts to tie the term to the “Black Monday” story may have resulted in the 20% definition, which journalists and editors probably simply copied from one another.

Origin of the ‘20%’ figure

In any case, that 20% figure is now widely accepted as an indicator of a bear market. Where there seems to be less overt consensus is on the time period for that decline. Indeed, those past newspaper reports often didn’t mention any time period at all in their definitions of a bear market. Journalists writing on the subject apparently did not think it necessary to be precise.

In assessing America’s past experience with bear markets, I used that traditional 20% figure, and added my own timing rubric. The peak before a bear market, per my definition, was the most recent 12-month high, and there should be some month in the subsequent year that is 20% lower. Whenever there was a contiguous sequence of peak months, I took the last one.

Referring to my compilation of monthly S&P Composite and related data, I found that there have been just 13 bear markets in the U.S. since 1871. The peak months before the bear markets occurred in 1892, 1895, 1902, 1906, 1916, 1929, 1934, 1937, 1946, 1961, 1987, 2000 and 2007. A couple of notorious stock-market collapses — in 1968-70 and in 1973-74 — are not on the list, because they were more protracted and gradual.

CAPE ratio

Once the past bear markets were identified, it was time to assess stock valuations prior to them, using an indicator that my Harvard colleague John Y. Campbell and I developed in 1988 to predict long-term stock-market returns. The cyclically adjusted price-to-earnings (CAPE) ratio is found by dividing the real (inflation-adjusted) stock index by the average of 10 years of earnings, with higher-than-average ratios implying lower-than-average returns. Our research showed that the CAPE ratio is somewhat effective at predicting real returns over a 10-year period, though we did not report how well that ratio predicts bear markets.

This month, the CAPE ratio in the U.S. is just above 30. That is a high ratio. Indeed, between 1881 and today, the average CAPE ratio has stood at just 16.8. Moreover, it has exceeded 30 only twice during that period: in 1929 and in 1997-2002.

But that does not mean that high CAPE ratios aren’t associated with bear markets. On the contrary, in the peak months before past bear markets, the average CAPE ratio was higher than average, at 22.1, suggesting that the CAPE does tend to rise before a bear market.

Moreover, the three times when there was a bear market with a below-average CAPE ratio were after 1916 (during World War I), 1934 (during the Great Depression) and 1946 (during the post-World War II recession). A high CAPE ratio thus implies potential vulnerability to a bear market, though it is by no means a perfect predictor.

Earnings to the rescue?

To be sure, there does seem to be some promising news. According to my data, real S&P Composite stock earnings have grown 1.8% per year, on average, since 1881. From the second quarter of 2016 to the second quarter of 2017, by contrast, real earnings growth was 13.2%, well above the historical annual rate.

But this high growth does not reduce the likelihood of a bear market. In fact, peak months before past bear markets also tended to show high real earnings growth: 13.3% per year, on average, for all 13 episodes. Moreover, at the market peak just before the biggest ever stock-market drop, in 1929-32, 12-month real earnings growth stood at 18.3%.

Another piece of ostensibly good news is that average stock-price volatility — measured by finding the standard deviation of monthly percentage changes in real stock prices for the preceding year — is an extremely low 1.2%. Between 1872 and 2017, volatility was nearly three times as high, at 3.5%.

Low volatility

Yet, again, this does not mean that a bear market isn’t approaching. In fact, stock-price volatility was lower than average in the year leading up to the peak month preceding the 13 previous U.S. bear markets, though today’s level is lower than the 3.1% average for those periods. At the peak month for the stock market before the 1929 crash, volatility was only 2.8%.

In short, the U.S. stock market today looks a lot like it did at the peaks before most of the country’s 13 previous bear markets. This is not to say that a bear market is guaranteed: Such episodes are difficult to anticipate, and the next one may still be a long way off. And even if a bear market does arrive, for anyone who does not buy at the market’s peak and sell at the trough, losses tend to be less than 20%.

But my analysis should serve as a warning against complacency. Investors who allow faulty impressions of history to lead them to assume too much stock-market risk today may be inviting considerable losses.


BabaLooey Philo Beddoe Fri, 09/22/2017 - 08:17 Permalink

I've lost count of the myriad of "warnings" and doom farticles now.ALL of these asinine "predictions" FAIL to take into account that the CENTRAL FUCKING SHIT EATING BANKS now control the casinos of shit, and therefore, NONE of this doom porn fecal matter is relevant.However, ZH has to pay the bills, so they throw up this red meat for us to shoot down. 

In reply to by Philo Beddoe

SheHunter BabaLooey Fri, 09/22/2017 - 08:28 Permalink

The central banks communicate with one another.  They will reach common consensus at some unknown time that market prices must be adjusted.  They will quietly position themselves to benefit from sharp, sudden, acute pullbacks in prices.  Price adjustments are inevitable, effective and expected.  Take a look at the 5, 10 year charts...we are top heavy.  Way top heavy.  Look how spooky is the market today and how far it can fall and jump in a single day.  Multiply that daily volatility in the advent of a real incident and you can see why I rarely stay in the market overnight these days. Reminders to position yourselves accordingly are not gloom and doom statements. 

In reply to by BabaLooey

yellensNIRPles SheHunter Fri, 09/22/2017 - 10:37 Permalink

Doom and gloom or not, they are correct. They are just very, very early. This all should have come tumbling down ages ago but the CBs have destroyed any semblance of normalcy in finance.So we wait. The complexity of the world guarantees that some catalyst at some point will cause the whole thing to come tumbling down (see 'n-body problem', much like Nicholas Taleb relates this concep to finance in Black Swan). A massive amount of control is possible, but absolute control lives firmly in the world of unicorns and leprechauns.This ends badly for most, very well for a select few.

In reply to by SheHunter

yogibear Fri, 09/22/2017 - 08:16 Permalink

Lol, Shiller how many times you gonna cry wolf?Now you have continued low rates and the central banksters buying stocks with infinite fiat.Your model is flawed.Go back into your cave and hibernate, it's fall.Try again next year as you always do.  

bshirley1968 Fri, 09/22/2017 - 08:19 Permalink

The shit show world has NEVER looked like this before.  The insanity and stupidity are at highs never before experienced.   NEVER before has it been so clear that EVERYTHING is fake.......manipulated.......and obvious lies being pumped out by TPTB with a straight face of sincerity.   Never before has this country had so much information in its hands and yet the people are so willfully blind and stupid to the truth.There is no "calling" this.  There will be a bear market, collapse,  whatever when it serves "their" timing  and purpose and not before.These articles are a waste of time.

buzzsaw99 Fri, 09/22/2017 - 08:25 Permalink

six fucking years we've been reading this crap waiting for a -10% drop meanwhile we're up +30%. someday the author might be correct but by then we will all be so old and broke from listening to his ilk that we won't even give a shit anymore.  go gum your cat food dinner and leave us the fuck alone bitchez.

bobert727 Fri, 09/22/2017 - 08:46 Permalink

What if, and I know it's a big if, in Round 1 (2008) the Big Banks went down and in Round 2 (2018) the Central Banks take the hit....... I can imagine a scenario where rates suddenly skyrocket and stock markets decline 30-40% and the FED has a massive loss on the books with their $4+ Trillion balance sheet and the other Central Banks of the world who are long stock markets, i.e. Swiss National Bank, Japan, etc. take massive hits.What will be their solution then? Print more? Yeah that will help!Just a thought....  

Batman11 Fri, 09/22/2017 - 09:22 Permalink

Neo-liberalism used Tulip Mania as an economic model.If we pump money into an asset class this creates real wealth.“Stocks have reached what looks like a permanently high plateau.” Irving Fisher 1929.That’s not real wealth you half-wit, that's just a "wealth effect" from excess liquidity in the markets.The Central bankers "wealth effect", you know its not going to end well. 

venturen Fri, 09/22/2017 - 09:32 Permalink

NO IT DOESN'T.At no time in history has interest rates been ZERO!At no time in history did you have all the world's central banks buying stocks!At no time in history did you have all the major world central banks printing money for banks and government! We have a circle of Central Banks eating their tails! It isn't going to end is a going end really  really really badly

gm_general venturen Fri, 09/22/2017 - 09:50 Permalink

A) All the world's central banks are not buying stocks, and B) very few are buying US stocks - any you can point to like Switzerland or Israel are buying relatively paltry amounts compared to the amount of US stocks that are traded, perhaps 1-2 days worth. No one has quantified how much US stocks Japan owns or even if they do hold any. Most are mostly buying bonds, or perhaps their own country's stocks. I am really getting tired of this meme, people pull up charts of central bank massive holdings without qualifying what percentage of holdings are what stocks in what country..You can say a boatload of US companies are buying their own stocks, but how much longer can they do that is the question. 

In reply to by venturen

gm_general Fri, 09/22/2017 - 09:41 Permalink

Sign of a bear market being imminent - virtually everyone assessing the possibility of a bear market feels they have to add the caveat "of course that doesn't mean the bear market is imminent" no matter how likely their argument makes it seem.

seattleslewsz Fri, 09/22/2017 - 09:48 Permalink

The markets will take a big loss sometime.  that we all know but to keep taking data and using it to say a crash is inevitable is just emotional pornography and a lot of people have lost a lot of money since the market was at 7k and is now over 22k.  It is getting silly at this point. only ShepWave has been correctly calling the markets. they put a chart of their GLD buy trade in July to prove their market calls. No other analysis does that. 

seattleslewsz Fri, 09/22/2017 - 09:48 Permalink

The markets will take a big loss sometime.  that we all know but to keep taking data and using it to say a crash is inevitable is just emotional pornography and a lot of people have lost a lot of money since the market was at 7k and is now over 22k.  It is getting silly at this point. only ShepWave has been correctly calling the markets. they put a chart of their GLD buy trade in July to prove their market calls. No other analysis does that. 

Ron_Mexico Fri, 09/22/2017 - 11:28 Permalink

the only question you have to ask yourself is this:  "Are central banks too big to fail?"  They are the issuers of fiat currency, and as such they are the ones whose credibility is in question. Human nature has driven them to proceed in a herd-like manner.  It's the old "if we all do it we can't all get in trouble" paradigm. But sometimes everybody's wrong, I guess.

Let it Go Fri, 09/22/2017 - 19:46 Permalink

We should be concerned because debt has exploded over the last several years. This means it is only prudent that we again come back and address the issue of where bad debt goes because when debt is written off there are always winners and losers. Efforts to call agreements to forgive debt a win-win are nothing more than putting lipstick on a pig.Fear is on the rise when it comes to growing debt and how much of it will never be repaid. When the economy heads south it will become obvious that not all debt is created equal and you do not want to be caught on the wrong end of a debt gone bad. The article below looks at the issue of defaults.