Stock Market Warning Signs

Sorry, there just aren’t any precise stock market warning signs or timing indicators to the market. And any website that suggests otherwise should be cautiously approached.

A simple metric is to look at the current PE of the major market indices. As the PE climbs, this means the investor in aggregate pays more for each dollar of earnings, which means that market is becoming more expensive. A rise in PE suggests a rise in expected earnings. If earnings don’t materialize, prepare for the downside, maybe!

The market PE can be checked versus historical averages at the Wall Street Journal site.

A leading academic, Robert Shiller of Yale, has, however created a metric to measure the relative valuation of the market – the CAPE – cyclically adjusted price earnings ratio. He probably would quarrel with describing it as part of stock market warning signs, but it can act as such.

He describes it as the following:

My colleague John Y. Campbell, now at Harvard, and I created the ratio more than 25 years ago. It works like this: Using inflation-adjusted figures, we divide stock prices by corporate earnings averaged over the preceding 10 years. Our ratio differs from a conventional price-to-earnings ratio in that it uses 10 years, rather than one year, in the denominator. It does so to help minimize effects of business-cycle fluctuations, and it’s helpful in comparing valuations over long horizons.

In the last century, the CAPE has fluctuated greatly, yet it has consistently reverted to its historical mean — sometimes taking a while to do so. Periods of high valuation have tended to be followed eventually by stock-price declines.

Still, the ratio has been a very imprecise timing indicator: It’s been relatively high — above 20 — for almost all the last 20 years, with the exception of 20 months, mostly in the recession of 2007-9, when prices tumbled and it fell as low as 13.32.

Shiller’s CAPE measurement can be found here.

Yet even the Yale professor’s musings have been challenged. Shiller admits that his cyclical adjustments do not account for low interest rates (which are arguably the driver of stock market gains in recent years).

Ultimately Shiller notes that the price of bonds affects the price of stocks. This is intuitive. Consider your own investing strategy – if you can get a higher rate of return from the relative safety of bond yields, would you not expect a higher rate of return to take on the higher risk of stock investment? (The answer is yes.)

So be wary of any promised indicator. Nothing is more accurate than hindsight.