As promised, following on from What does a correction look like? last week, we’re taking a quick look at how expensive markets were around previous crashes, and what that tells us about markets now.
We have highlighted numerous times that the US stock market is overvalued. It would have to fall more than 40% just to return to its long run average (based on cyclically adjusted price earnings ratio, CAPE, see chart below).
Yet markets can stay overvalued for years, and they can get more over-valued e.g. the US market is still less over-valued than in 1999, the biggest investment bubble in 300 years. But as you can see on the graph below, it is now at the level which preceded the Wall Street Crash, and much higher than before the 1987 Crash.
Moreover, the US market is overdue even a sober correction, let alone something more worrying. For example, since 1928 a 20% correction occurs every 2 years on average – it is now over 5 years since the last 20% correction. This is VERY stretched.
Earlier in the year the US stock market didn’t just close higher for 12 straight days, but also reached new all-time highs on each of those days. The last time this happened was January 1987. That year cracks only really began to appear from June, and many of us can remember what happened on Black Monday in October.
Chart 1: CAPE (Cyclically adjusted price-earnings ratio)