The U.S. stock market is not forming a bubble. That’s important to emphasize in order to counter the popular narrative that the stock market is as frothy today as it was at the top of the internet bubble in early 2000.
In fact, it’s nowhere close to being comparable, according to an academic study that quantifies the probability of a bubble that bursts.
The absence of a bubble doesn’t mean the stock market couldn’t decline in coming months. It very well could. But a bubble bursting is more than a garden-variety decline, and the bubble narrative that has emerged in recent months is forecasting something above and beyond such a decline.
That something more, according to the recent study that quantifies crash probabilities, traces to the magnitude of the price runup during the inflation phase of the bubble and the magnitude of the crash that subsequently ensues. Entitled “Bubbles For Fama,” the study was conducted by Robin Greenwood and Andrei Shleifer of Harvard University and Yang You of the University of Hong Kong. They define a bubble to be a gain of at least 100% over a two-year period, followed by a crash in which the market declines by at least 40% over the subsequent two years.
To be sure, not all price runups that large lead to such a crash. But more often than not they do, according to the professors — 53% of the time, to be exact. They furthermore found that this probability grows along with the magnitude of the prior runup. When the market advance is 150%, for example, the probability of the subsequent drop grows to 80%. When the two-year runup is even greater, a subsequent decline becomes overwhelmingly likely.
The professors calculated these probabilities when focusing on industries, in part because the market itself has experienced few bubbles over the decades — making it difficult to reach statistically robust conclusions. Nevertheless, their conclusions allow us to put the current stock market’s performance in context. The S&P 500
SPX,
is just over 3% higher now than where it stood two years ago, and that’s not remotely enough to even be called a runup — much less one that increases the probability of a crash.
How valuation models stack up
Does overvaluation increase the probability of a two-year drop of at least 40%? That’s worth asking, since the table below shows that the stock market is either moderately or extremely overvalued according to eight different valuation models that have good historical track records. But the professors find that overvaluation increases the probability of a big two-year drop only when the overvaluation is accompanied by a prior price runup of at least 100%.
That’s because valuation plays a relatively small role in predicting the stock market’s shorter-term prospects. The eight indicators chosen for the table below were picked because of their superior record when forecasting the market’s subsequent 10-year return.
The bottom line? The stock market is not in a bubble, but its prospects for performance over the next decade are mediocre at best.
| Latest | Month ago | Beginning of year | Percentile since 2000 (100% most bearish) | Percentile since 1970 (100% most bearish) | Percentile since 1950 (100% most bearish) | |
| P/E ratio | 24.15 | 23.21 | 22.23 | 70% | 80% | 86% |
| CAPE ratio | 30.08 | 28.91 | 28.32 | 80% | 85% | 89% |
| P/Dividend ratio | 1.57% | 1.63% | 1.74% | 85% | 88% | 92% |
| P/Sales ratio | 2.48 | 2.38 | 2.19 | 91% | 96% | 97% |
| P/Book ratio | 4.24 | 4.08 | 3.75 | 94% | 93% | 95% |
| Q ratio | 1.79 | 1.72 | 1.58 | 92% | 97% | 98% |
| Buffett ratio (Market cap/GDP ) | 1.73 | 1.59 | 1.46 | 92% | 97% | 97% |
| Average household equity allocation | 46.2% | 44.9% | 44.9% | 92% | 92% | 94% |
Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at mark@hulbertratings.com
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This story originally appeared on Marketwatch
