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History Points to Market Correction

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History Points to Market Correction

For those analysts who have a sense of perspective about cycles in the markets, we appear to be living in very strange economic times, indeed. There will always be pundits on each side of the argument, the pessimistic bears and the optimistic bulls. (It's worth stating that if someone's hedge fund is long or short, they have a vested interest in filling the airwaves and online echo chambers with support for their views.)

market-lossUnless you subscribe to the idea of clairvoyance, nobody can know for certain where any particular market is headed. However, historical comparisons make clear that equities in the U.S. are far more likely to head lower than they are to climb higher over the medium-term.

Using History as a Guide

We often see declarations about how we live in "unprecedented times" from commentators pining to make a point. This is especially prevalent in politics, where one party is always trying to position itself as the merchants of change in opposition to the status quo. Yet the same is often seen in economics. When it serves their interests, pundits are apt to tell us that we've never seen the likes of what is unfolding—or what is just around the corner.

This can be a powerful appeal, but it is also powerful when someone can cite historical precedent to support a particular pattern or prediction. For instance, it should be telling that the aggregate price-to-earnings (P/E) ratio for all of Wall St is about 60% above its historical average. (P/E ratios are a very standard metric used to judge the long-term performance of a company.)

Historical CAPE ratio chart. Source: realinvestmentadvice.com Historical CAPE ratio chart. Source: realinvestmentadvice.com

The chart above demonstrates the history of the market-wide P/E ratio over the long run. The only times the cyclically adjusted P/E ratio (commonly abbreviated as CAPE 10 or Shiller P/E) for the stock market as a whole has been higher? 1929, 2000, and 2007. Those dates ought to stand out as directly preceding the biggest stock bubbles to ever pop—the market crash that preceded the Great Depression; the end of the dot-com bubble; and the housing collapse that led to the financial crisis (and "Great Recession").

Beyond echoing the warning signs of past market bubbles that were infamously pricked, there's another point to watching these historically elevated P/E levels. Regression to the mean, or the tendency for trends well above or well below a baseline average to "come back to earth," is a powerful force in virtually all human endeavors. This concept alone makes it increasingly likely (as opposed to certain) that a market correction in equities is coming.

Past Performance Is No Guarantee . . .

Of course, there is a certain danger in believing that history as a guide is an infallible tool. As any advisor with scruples is careful to warn, past performance is no guarantee of future outcomes. This is absolutely true; but it doesn't mean we ought to ignore the past in order to provide context and inform our decisions.

Artwork of Jon Berkeley from the cover of The Economist, Feb. 20, 2016 Artwork of Jon Berkeley from the cover of The Economist, Feb. 20, 2016

Whether or not the stock market correction is just over the horizon or still years away—there's another advising adage about not trying to time the market—there's no doubt that investor and traders alike have become too reliant upon intervention from the Federal Reserve to keep asset valuations propped up.

It's reasonably likely that in the absence of continued stimulus and QE from the Fed, the markets will realize that the "emperor has no clothes." We know that the Fed has basically run out of QE-style ammunition, not to mention that such measures tend to offer diminishing returns. It's a matter of how long before Wall St wakes up?


The opinions and forecasts herein are provided solely for informational purposes, and should not be used or construed as an offer, solicitation, or recommendation to buy or sell any product.

About the Author

Everett Millman

Everett Millman

Analyst, Commodities and Finance
Managing Editor

Everett has been the head content writer and market analyst at Gainesville Coins since 2013. He has a background in History and is deeply interested in how gold and silver have historically fit into the financial system.

In addition to blogging, Everett's work has been featured in CoinWeek, Advisor Perspectives, Wealth Management, Activist Post, and has been referenced by the Washington Post.

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