Historic fundamentals of stock market valuations, tools that have been used by investors and analysts for years to gauge if stocks are cheap or expensive, are screaming “stock market crash ahead.”
Let me start by pointing out that earnings for the S&P 500 have now declined for the five consecutive quarters. This is almost unheard of.
In the third quarter of 2016, Wall Street analysts predict that corporate earnings for the S&P 500 companies will decline by another 2.1%. (Source: “Earnings Insight,” Factset, September 2, 2016.) If this turns out to be true (which I fully expect), it will be sixth consecutive decline in earnings for the S&P 500, and it would be the longest streak of lower earnings since the financial crisis of 2008 and 2009!
Earnings are the most basic driving force behind stock prices. Consistently declining earnings has never been good for stocks. But contracting earnings are just one problem. Stocks are historically overpriced compared to their earnings.
The cyclically adjusted price-to-earnings (CAPE) multiple for stocks sits at 27.07. In other words, adjusted for economic cycles and inflation, investors are willing to pay $27.07 for every one dollar of earnings on U.S. stock markets. (Source: “U.S. Stock Markets 1871-Present and CAPE Ratio,” Yale University, last accessed September 7, 2016.)
How significant is this 27.07 figure?
The last time investors were willing to pay this much on the stock market, it was in October of 2007. This is just after the stock market had formed a top.
From a historical perspective, the CAPE multiple of 27.07 is extremely high. Since 1881, U.S. stock markets have only traded above a CAPE multiple of 27.07 five percent of the time. And if you look at the monthly average CAPE multiple of 16.69 since 1881, by that measure, the U.S. stock markets are overvalued by over 62%!
Stock Market Outlook for 2017
I have seen several stock market crashes over my career. In all of them, there was one thing in common; investors’ disbelief.
Despite falling earnings and extreme valuations, some well-known stock advisors are still calling for higher key stock indices. Don’t buy into that false optimism.
Remember, irrationality can go on for some time, but reality always kicks in. The fundamentals are eventually going to matter, and when they do, we could see a major stock market crash. As it stands, I don’t see the rest of 2016 and 2017 to be good years for stocks.