An overvalued stock market doesn't have to crash

Permabears always resort to one answer when asked “why do you think the bull market in stocks is over”.

“The stock market is overvalued. Its valuation is far above the long term average”.

Here’s Tobin’s Q, a popular valuation indicator.

I’ve stated that valuation alone cannot cause a bear market. Valuation is just one of many factors that our Medium-Long Term Model uses to predict bear markets.
For example, the U.S. stock market soared from 1995-2000 despite insanely high valuations. Anyone who missed out on that chunk of the bull market would’ve missed out on massive profits.
Our Medium-Long Term Model predicts that the current bull market has at least 2-3 years left. But the U.S. stock market doesn’t have to crash when this bull market ends. Valuations can mean-revert without crashing. Here’s how.

Method #1: A megacrash

This is the situation that permabears allude to. It is also the most obvious way for mean-reversion to happen. In this method,

High valuations result in a megacrash, which cases the stock market to mean revert to its long term average valuation.

The only 2 true megacrashes over the past 100 years are the Great Depression and the Great Recession.
Both scenarios are unlikely to happen during the next bear market. Megacrashes tend to occur during deflationary periods. Today, the world is awash in money thanks to central banks’ quantitative easing. Hence, the next bear market and economic recession will probably be accompanied by mild inflation and not deflation. That is why I think a deflationary megacrash is unlikely.

Method #2: high inflation kills valuation

Valuation is a simple formula.

Nominal price of the stock market / nominal value of the underlying assets.

As you can see, there are 2 components to this equation. If you hold “nominal value of underlying assets” steady, the only way for valuation to come down is if “nominal price of the stock market” falls. In other words, the numerator falls while the denominator is the same. That’s the megacrash case.
Another way for valuation to come down is the reverse. If the “nominal price of the stock market” is flat while the “nominal value of the underlying assets” rises, then valuation falls. In other words, the numerator is flat while the denominator rises. This is an inflationary case.
Here’s a simple example. Let’s say a gold company’s market cap is $1 billion. If the price of the company’s gold soars but the company’s market cap is unchanged, then the company’s “valuation” tanks.
This is what happened in the 1970s. The S&P 500 was overall flat during the 1970s. But the stock market’s valuation tanked because high inflation caused the “nominal value of underlying assets” to soar.
In other words, the S&P 500 fell significantly when adjusted for inflation (real-terms).
Here’s the S&P 500.

Here’s inflation.

Here’s the U.S. stock market’s valuation, which tanked.

*Inflation frequently hit double digits in the 1970s.
I don’t think the U.S. stock market’s valuation will mean-revert this way during the next bear market / recession. The 1970s inflation was the result of multiple oil-related political crisis (e.g. OPEC oil embargo). The U.S. is now largely self-sufficient in terms of energy, so these crises are unlikely to repeat. Thus, I don’t expect inflation to hit double digits again.

Method #3: the most likely method.

If you combine a normal bear market (e.g. a 30-40% decline in the stock market) with mid-high single digit inflation, then the stock market’s valuation will fall significantly over a few years.
In other words, this combines Method #1 and Method #2, but is not as extreme as either case.
Jeremy Grantham (GMO’s hedge fund manager) thinks this type of bear market will happen during the next bear market. I agree.

  1. I do not see the case for a megacrash. Megacrashes are accompanied by deflationary forces. We live in a world where potential inflationary forces exceed potential deflationary forces.
  2. I do not see the case for double digit inflation. I do see the case for higher inflation than what we have presently. Trillions of dollars of global QE have caused asset “bubbles” in everything from crypto to fine art. This flood of capital is slowly working its way into the economy (trickle down economics), albeit at an extremely slow pace. Inflation and CPI will rise once the economy fully recovers.

6 comments add yours

  1. Troy,
    Do you have any predictions on the first few days of the trading year and 1st qtr?
    1) are the first few trading days of the new year (1st qtr) typically met with capital inflows? Or
    2) the first few days met with profit taking ( in 2018’s instance profit taking would be taxed under the new tax plans rate of capital gains for 2019’s tax season)
    Is this relevant at all for the first few trading days of the new 2018 trading season?

    • No predictions for the first few days.
      I don’t think inflows/outflows and profit taking are consistent indicators.
      My problem with capital inflows/outflows is that they don’t reflect the whole picture. You can have extremely high capital outflows from ETFs be offset by a lot of individual share buying (which is what happened this past month).
      With regards to Q1 2018, I think we’ll see the stock market roll over (eg slightly up from January-February, then down from February to March). This is just a guess, but is supported by pattern analysis as well.
      I’ll post the pattern on January 2’s post.
      Happy New Year!

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