Here’s a chart of the Price: Earnings (P/E) ratio on the S&P500 courtesy of Dr. Robert Shiller. There’s over 130 years of data here. First, notice how the line is mean-reverting? It fluctuates like a sine wave rising for 15ish years to distinctly above the mean, then falling 15ish years to distinctly below the mean. If nothing else, this should tell you that what comes after a 23 year period above the mean (1988 – now) would probably be 10-20 years with a P/E below the mean. There’s our starting point.
Digging deeper, we observe there are 2 distinct types of periods in this 130+ year waveform.
Type A: Nice & Boring.
These are long (secular) 15(ish)-year periods where the average P/E rises in a very gentle straight line. It oscillates like a smaller sine wave above & below that gently sloping upward trend line. Each time the P/E dropped along the way was a business cycle recession (no big deal). Then the process reverts to the mean and goes into reverse: the 15(ish) year average P/E trend line gently falls while the P/E gently fluctuates with more business cycle recessions. From start to finish it takes roughly 35 years.
- A great example is 1885 – 1920. The average P/E rose in a gentle straight line from roughly 14 to 20 while fluctuating by small amounts. Then it calmly reversed itself and went down over the next 20 years (+/-) from 1900 – 1920. 35 years.
- The same thing happened from 1948 to 1982. 34 years.
- Don’t those 2 periods look very similar? Nice & boring. No one panics.
Type B: Boom & Bust
Then there’s type B. This is a different animal altogether. In the 130+ year history of the S&P500 there is one example of a complete cycle, and I suggest we’re 3/4ths of the way through the second example. Look at 1920-1929 on the chart. This is the first half of the cycle. It’s a 10-year rocket without a single 5% drop along the way. It does not resemble in any way the first half of the type A cycle. The P/E did nothing by rise. It rose far faster and further than ever before, and peaked at 30 — a 6X increase from where it started in 1920. This was a massive bubble. A boom if there ever was one. Stocks went through the roof. Life was great. Unsustainably great.
Enter the second half of type B (bust). This period unwound the previous largesse and took the better part of 2 decades to do it: 1929 -1948. This -as we know – was a balance sheet recession (aka the great depression in the 1930s + WWII). The chart for this period looks nothing like the gentle dropping average P/E that was seen in the second half of type A. Instead, this looks like a seismogram (wrote the engineer with a degree in geophysics). From 1929 to 1948 the chart crashes from 30 to 8 but sees epic rallies and crashes of decreasing amplitude until it peters out at the end.
I mentioned there are two examples of the type B. One was the 1920 – 1929 (boom) then 1929 -1948 (bust). The other is what we’re in now: 1982 -2000 (boom) followed by 2000 – (2025?) bust.
1920-1929 resembles 1982-2000 (the ride up). Admittedly the 1982 -2000 boom was twice as long and went higher than that experienced before the great depression.
- unmatched expansions of credit and banking.
- unmatched stock market bubbles.
- unmatched P/Es. The 1999 peak saw a P/E of 43. Far more than the 30 in 1929.
- unmatched rise in P/E from the beginning of the cycle.
- unmatched growth in prosperity.
- unmatched use of leverage.
- virtually no sizable and sustained stock market drops along the way. Straight up.
- unmatched greed. Ratios of highest to lowest paid skyrocket.
1929 -1948 resembles 2000 – 2025? (the ride down)
- an unmatched bill needs to be paid. Total US debtload is worse in the current cycle than the previous one (really not good).
- banking system brought to its knees.
- unmatched losses on real estate.
- unmatched levels of paper wealth destroyed.
- unmatched real unemployment (U6) levels.
- unmatched drops in stock market.
- unmatched drops in P/E.
- unmatched levels of homelessness, foodstamps, desperation and despair.
- how long do think it will take to stabilize the US debt/GDP ratio? 2025 looks about right.
If we follow the same recipe now as the only other balance sheet recession, the P/E should collapse to where it was at the beginning of the cycle (was 8 in 1982). Probably 7 on the low side and 10 on the high side. That translates to an S&P500 bottoming in the 400 – 550 range. (Dow in the 4000s – 5000s). That would represent the ultimate secular (long term) stock market bottom for this cycle.
Perhaps we hit that next year or 2013. What would it take for this ? Just reality to happen.
- European bank regulators and politicians run out of tricks.
- US bank regulators and politicians run out of tricks.
- Chinese and Japanese bank regulators and politicians run out of tricks.
- The impact of any one of these is enough to bring the others down too (make those events happen as well).
However, the above realities cannot be avoided. They can only be stalled. Why? Because stalling is only manufactured via more debt, and we’re quickly reaching the outer limits of that process. In so doing, a stall will make the collapse larger because the cost of stalling is a larger problem to solve ultimately (more debt!).
Look at the 130 year chart one last time. Now zero-in on 2009-2011. That rise in the P/E (& stock market) is what you get for the roughly $6T tab that was racked up — here in the US. That’s QE1, QE2, bailouts, budget deficits for 2 years. Tell me that was not pointless. See that little break/drop in the sudden rise? That was the brief window of reality that occurred in between QE1 & QE2 last summer. And what about the sudden drop at the end? That too is what happens when QE shuts off and reality begins to take hold. Clearly the P/E will do what it has done in the past: revert to the mean and. Thereby dropping to a level where the next secular bull market in stocks may begin. For some reason the US Congress and Fed think they can stop the process that has a 130+ year history.
If the Fed and US Congress understood this chart, they’d immediately agree on a path to balance the budget deficit within 5-6 years (as fast as possible). They’d then continue on the path and begin paying down debt, not just stabilize it. It goes without saying there would not be a QE3. Quite the opposite. The Fed would begin a long and slow unwinding of its bloated balance sheet over the next 5-6 years. Yes, these actions would guarantee a 5-6 year recession at least half as painful as the 1930s great depression. But not taking actions to reverse our debt means we increase the chances of a collapse larger than the great depression. What stopped the great depression? WWII. A key element of that period: Germany was tired of having to make payments to the rest of Europe for WWI reparations. Germans felt alone and victimized by Europe. Fast forward to year 2011. Germany is being asked to bail out Europe — making payments to the rest of Europe.
History does repeat. But what type?