As U.S. stocks continue soaring to record high after record high, investors anticipating
an inevitable plunge have yet another cause for sleepless nights.
The CAPE ratio, a measure of stock valuations devised by Nobel Laureate economist
Robert Shiller of Yale University, is now at a higher level than it was before the Great Crash of 1929,
the Financial Times reports, adding that the only time the CAPE was even higher preceded
the dotcom crash of 2000-02. However, the FT notes, there are some differences between 1929
and 2018 that make the CAPE parallel less terrifying for investors.
From their previous bear market lows reached in intraday trading on March 6, 2009,
through their closing values on January 12, 2018, the S&P 500 Index (SPX) has gained
and the Dow Jones Industrial Average (DJIA) has advanced 299%.
Regarding the CAPE valuation analysis, there are several key limitations.
Drawbacks of CAPE
According to investment manager Rob Arnott, the founder, chairman and CEO of
Research Associates, CAPE has been on an upward trend over time.
This makes sense both to him and to the FT since the U.S. as progressed from being
essentially an emerging market to the world's dominant economy during the course of
more than a century. As a result, both believe that an increasing earnings multiple
for U.S. stocks would be justified. While the current value of CAPE is above its
long term trend line, the difference is much smaller than in 1929,
Moreover, as the result of 1930s reforms such as the creation of the
Securities and Exchange Commission (SEC) and tightened financial reporting standards,
the quality of reported earnings today probably is much higher today than in 1929.
Accordingly, the value of CAPE for 1929 arguably is understated, given that its denominator,
reported corporate profits, probably is overstated by today's standards.
The FT also points out that CAPE does not account for the level of interest rates.
When rates are low, as they are today, "discounted future earnings are higher,
and it is reasonable to pay more for stocks," the FT says. Indeed,
the FT could have added that CAPE looks backwards at 10 years of corporate earnings,
whereas market valuations are, at least in theory, based on expectations of future profits.
The 1929 Crash
The Great Crash of 1929 is mostly associated with plummeting stock prices on two
October 28 and 29, 1929, in which the Dow fell 13% and 12%, respectively.
But this was only the most dramatic
episode in a longer term bear market.
After peaking at a value of 381.17 on September 3, 1929, the Dow eventually would hit
bottom on July 8, 1932, at 41.22, for a cumulative loss of 89%. It would take until
November 23, 1954 – over 25 years later – for the Dow to regain its pre-crash high.
The Great Crash is generally considered to be one of the factors contributing to the
onset of the Great Depression of the 1930s.
'Unintended and Undesirable Consequences'
Concerned about speculation in the stock market, the Federal Reserve "responded
aggressively" with tight money policies starting in 1928, which helped to spark
the Great Crash, per the Federal Reserve Bank of San Francisco (FRBSF).
Moreover, in 1929 the Fed pursued a policy of denying credit to banks that extended
loans to stock speculators, according to Federal Reserve History.
"The Fed succeeded in putting a halt to the rapid increase in share prices, but in doing so
it may have contributed one of the main impulses for the Great Depression,"
as the FRBSF Economic Letter wraps up. "Detecting and deflating financial bubbles is
difficult," is a conclusion of the Fed History piece, adding that "Using monetary policy
to restrain investors' exuberance may have broad, unintended, and undesirable
'Playbook' For Limiting Crash Damage
Both sources also indicate that, in the aftermath of the worst days of the crash,
in October 1929, the Federal Reserve Bank of New York pursued an aggressive policy
of injecting liquidity into the major New York banks.
This included open market purchases of government securities plus expedited lending
to banks at a decreased discount rate.
This action was controversial at the time.
Both the Federal Reserve's Board of Governors and the presidents of several other regional
Federal Reserve Banks claimed that president George L. Harrison of the New York Fed
has exceeded his authority. Nonetheless, this is now the accepted "playbook"
for limiting the damage from stock market crashes, per Fed History.
In the aftermath of the 1987 stock market crash, the Fed under Chairman Alan Greenspan
moved aggressively to increase liquidity, particularly to bolster securities firms that needed
to finance large inventories of securities that they had acquired by filling the avalanche of
sell orders from their clients, per a research paper from the University of Notre Dame.
In response to the financial crisis of 2008, the Fed under Chairman Ben Bernanke launched
an aggressively expansionist monetary policy designed to prop up the financial system,
the securities markets, and the broader economy. Hinging on massive purchases of
government bonds to push interest rates near zero, this policy is frequently referred to
Greenspan, meanwhile, is among those who now warn that, by continuing this easy
money policy for years after the 2008 crisis was stemmed, the Fed has created new
financial asset bubbles.
(For more, see also: Stocks' Big Threat Is a Bond Collapse: Greenspan.)
Also in response to the 1987 crash, the New York Stock Exchange (NYSE) and
that would halt trading after a large drop in prices.
These safeguards are designed to slow a wave of panicked selling,
and help the markets stabilize.
New Era, New Risks
On the other hand, computer-driven program trading, which caused rapid waves of frenzied
selling in 1987, as well as later violent market downdrafts such as the "Flash Crash,"
has increased in speed and pervasiveness.
The upshot is that computerized trading algorithms may pose one of the biggest threats
to the markets today.
(For more, see also: Could Algo Trading Cause a Bigger Crash Than 1987?)
After the experience of 1929, the Fed has been indisposed to tighten monetary policy in
an attempt to deflate asset bubbles. However, as economic growth reports improve,
the Fed is increasingly concerned today about keeping inflation in check.
Any miscalculation that raises interest rates too high, too fast could spark a recession
and send both stock and bond prices tumbling downwards.
(For more, see also: How The Fed May Kill The 2018 Stock Rally.)
Additionally, an increasingly interconnected world economy means that the spark that
ignites a stock market plunge in the U.S. can be lit anywhere around the globe.
(For more, see also: 5 Global Risks That Could Hammer Stocks in 2018.)
Read more: Why The 1929 Stock Market Crash Could Happen In 2018 | Investopedia