Finweek English Edition
Is the US market close to a crash?
Schalk Louw looks at three indicators which address the probability of a US market correction.
on several occasions in the past I have referred to the fact that no one can determine what will happen tomorrow with absolute certainty. Some readers may disagree with me. If it’s Friday today, then I can tell you with absolute certainty that I will braai tomorrow. That’s a sure thing. But the truth is that I’m planning to braai tomorrow and based on what I do most Saturdays, there is a high probability that I will in fact braai.
If I should ever be so lucky, one person that I would love to invite over for a braai would be well-known investor Warren Buffett.
On more than one occasion Buffett has mentioned that one of the most important pillars his investment decisions rest on is probability. In his own words: “We make investment decisions based on our evaluation of the most profitable combination of probabilities.”
This week I would like to apply the concept of probability – not to look for investment opportunities, but rather to answer the question of what the probability is of a market crash, or more specifically, a crash in the US stock market, the largest one in the world. To answer this question, I will discuss three indicators which address the probability of a US market correction.
Market capitalisation as a percentage of GDP
I mentioned Buffett earlier, but this ratio is also known as the Buffett indicator. This ratio simply measures the total US market capitalisation (Wilshire 5000) as a percentage of the US GDP, and it shows us when the US stock market is trading in inflated territory. Every time that the market capitalisation (size of the market) traded at higher levels than GDP over the last 30 years (higher than 100% of GDP levels), the US stock market was not only trading at levels close to boiling point, but it also experienced a massive correction shortly thereafter.
Not only are current levels more than 100% the size of GDP, but it’s trading at more than double the size of GDP, which is much higher than during both the dotcom and US housing bubbles. This indicator, therefore, shows us that the probability of a market correction is quite high.
Price-to-earnings ratio levels
The price-to-earnings ratio (P/E) must be one of the most used ratios when it comes to the valuation of shares, and it is calculated by simply dividing the price of a share (or index) by its earnings. The higher the P/E, the more expensive the share. However, the problem with the standard P/E is that it only considers the past 12 months’ earnings, which doesn’t give us a good cyclical image. That is why experts prefer to use the Shiller P/E, or the CAPE ratio. The CAPE ratio uses the same formula as the standard P/E, but it considers the share’s earnings over a 10-year period to consider and smooth out any fluctuations in corporate profits that occur at different intervals during a business cycle.
Even when we consider the CAPE of the US stock market (S&P500) over the last 150 years, it’s important to note that every time this ratio skyrocketed, a sharp market correction followed soon thereafter. Now, while the US market is not yet trading at the dotcom bubble levels seen in 2000, we have surpassed 1929 levels and I think it’s safe to say that the probability of a market correction, according to this indicator, is getting higher by the day.
US 10-year Treasury constant maturity minus 2-year Treasury constant maturity
When we consider the difference between the US 10-year Treasury constant maturity rate and the 2-year Treasury constant maturity rate, the US experienced a recession within the 2-year period that followed every time the short rates traded higher than long rates over the past 45 years (i.e., where the difference was negative). Although we found this difference in negative territory at the end of 2019 for a short while and saw the US in a recession for a short while thereafter, at current levels things are still relatively normal. That means that according to this indicator, the probability of a market correction is not as high as with the two other indicators. Be warned, however: The US Federal Reserve already indicated that the next interest rate move will most probably be upwards, which may push the 2-year rate higher and could lead to a negative difference. ■