An Expensive Market

PARIS – Yesterday, we reported that the U.S. manufacturing sector shrank for the fifth month in a row in December. We could have added that it is now back to levels last seen in July 2009 – in the immediate aftermath of the global financial crisis.



Image via


We could have mentioned, too, that the Baltic Dry Index – which tracks the cost of shipping raw materials by sea – just hit a record low. We’ve been citing many other fundamental indicators all pointing the same way – toward a weakening global economy.


1-BDIThe BDI (Baltic Dry Index, an index of international dry bulk shipping rates) has suffered a collapse of 96% since its 2008 peak – with that it is the only serious competitor still in contention for the “greatest crash in history” title, which is currently held by the stock market of Cyprus – click to enlarge.


Why, then, are stocks – which are supposed to look ahead – still telling us that the coast is clear?

The Dow fell about 2% last year. And the S&P 500 fell by just under 1%. Neither was enough to cause alarm. And after a rough start on Monday, the mainstream press reports that prices “stabilized” yesterday.

But according to Nobel prize-winning economist Robert Shiller, U.S. stocks have almost never been so expensive. His cyclically adjusted price-earnings ratio – or CAPE ratio – looks at the relationship between share prices and the average inflation-adjusted earnings from the previous 10 years.

This controls for – or “smoothes” – year-to-year swings in corporate earnings, which can be highly volatile. As a result, Shiller says, it gives a more accurate picture of what kind of value is on offer.


Right now, the CAPE ratio for the S&P 500 is 25.5. Only three times in the last 135 years has it been higher – in 1929, 2000, and 2007. None of these turned out to be a good time to add to your stock account.


2-CAPE-RatioThe CAPE ratio (a.k.a. P/E-10, or Shiller-P/E ratio) is at an extremely high level.


But wait… The story is a little more complicated. The Dow and the S&P 500 have been buoyed up by the performance of a few companies that have done very well.

The tech-heavy Nasdaq, too, owes its positive numbers to the so-called FANG stocks – Facebook, Amazon, Netflix, and Google (now called Alphabet).

These four tech darlings have been running wild – reminding us of the dot-com craze of the late 1990s. And all (bar Alphabet) trade at price-to-earnings ratios of more than 100. But if you look beyond the major indexes, you don’t see stocks running wild… you see them running for cover.


A “Stealth” Bear Market

In fact, it looks as though a “stealth” bear market has already begun. For example, the median stock in the Russell 3000 – a broad measure of the U.S. stock market – has fallen 20% since hitting its 52-week high.

That should ring some bells. A 20% fall from a 52-week high is a standard definition of a bear market. What is going on? Dr. John Hussman of Hussman Funds speaks for us:


“I remain convinced that the U.S. financial markets, particularly equities and low-grade debt, are in a late-stage top formation of the third speculative bubble in 15 years.

On the basis of the valuation measures most strongly correlated with subsequent market returns (and that have fully retained that correlation even across recent market cycles), current extremes imply 40-55% market losses over the completion of the current market cycle, with zero nominal and negative real total returns for the S&P 500 on a 10-to-12-year horizon. These are not worst-case scenarios, but run-of-the-mill expectations.”


3-wmc160104aIn terms of Dr. Hussman’s proprietary stock market valuation measures, the current market is actually the second most overvalued ever. Only the year 2000 mania peak still towers above it – though not in terms of the ratio of non-financial debt to gross value added (in red), as this measure has reached a new record high. Read, US listed companies are up to their eyebrows in debt. The measure in blue has been chosen on the basis of extensive back-testing (the ratio of non-financial market cap to national non-financial gross value added incl. foreign revenues). According to Dr. Hussman, this valuation measure is the by far best predictor of subsequent 12 year returns – click to enlarge.


Now we will speak for ourselves: We recall that in 2000 – the same year we suggested shifting out of U.S. stocks – Warren Buffett looked ahead. And he saw a “Lost Decade” coming for the U.S. stock market.

Stock prices had gotten so high relative to GDP that he reckoned it was unlikely that we would see a positive return over the next 10 years. He was right. Stocks went up until 2007… and then crashed down again, ending the decade lower than where they began it. Investors lost money. And now? Hussman continues:


“The risk cycle has already turned, and the familiar canaries in the coalmine – market internals and credit spreads – have been deteriorating persistently, in the same way that deteriorating internals and sub-prime defaults were the first warning signs to emerge in 2007… the consequences of years of distorted capital flows and yield-seeking are already unfolding.”


Our proprietary stock market indicator, based on research by former ValueLine analyst Stephen Jones, shows much the same thing: losses for U.S. stock market investors as far as the eye can see. Unless, that is, you can see further than 10 years ahead.

Until then, our indicator predicts lower U.S. stock prices, as the equity market adjusts to high current prices, over-regulation, a crushing debt load, misallocation of resources, and aging populations. Will Jones and Hussman be right? Will we be right? Who knows?


4-wmc160104bHere you can see the inverted chart of the market cap/gross value added chart (blue) with the subsequent 12-year annual S&P 500 return overlaid in red. Hand and glove come to mind.


But if you check your broker statement in 2025… and find you have only half as much real wealth as you have today… remember: We warned you. If, on the other hand, you’ve made a lot of money by ignoring us… please forget we said anything.


Charts by: StockCharts, John Hussman, Bonner & Partners


Image captions by PT


The above article originally appeared at the Diary of a Rogue Economist, written for Bonner & Partners. Bill Bonner founded Agora, Inc in 1978. It has since grown into one of the largest independent newsletter publishing companies in the world. He has also written three New York Times bestselling books, Financial Reckoning Day, Empire of Debt and Mobs, Messiahs and Markets.



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