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Warren Buffett made a comment to Berkshire Hathaway shareholders (written spring 2017) on major market declines – something he rarely does:
“The years ahead will occasionally deliver major market declines – even panics – that will affect virtually all stocks. No one can tell you when these traumas will occur – not me, not Charlie, not economists, not the media. Meg McConnell of the New York Fed aptly described the reality of panics: “We spend a lot of time looking for systemic risk; in truth, however, it tends to find us.”
So, it is very difficult to see big falls coming. And certainly estimating the timing of large declines is pretty well impossible. There were many people – particularly value investors – who said the market was due for a large fall in 1996 based on examination of the fundamentals. Some of these people lost their fund management jobs in 1998-9 after betting on a fall.
So, we have to be very cautious in stating (a) that there WILL be a fall, and (b) WHEN it will happen. The market is just not that predictable.
That said, there are occasions in history when the probabilities of a major fall are higher than at other times. These probabilities are raised if:
- The market is exceptionally highly priced relative to the proven facts about the companies that make up the market, e.g. reported earnings. High equity pricing is based to a large degree on anticipation of good things to come, rather than on the solid ground of what has been demonstrated. For example, many people look at the US tax cuts, economic growth and the potential of companies like Google, Facebook, Netflix, Apple, Amazon, Microsoft, etc., and say that everything is set fair for a much improved profit performance; in a couple of years from now you’ll wonder why shares were price at such a “modest” level, they tell us.
- The economic backdrop is risky. This often occurs toward the end of long economic up-turns. GDP grows, interest rates are low and people have not seen a crisis for a while. Thus they leverage-up to increasingly risky levels. Lenders become lax about lending standards. Loans are approved based on an assumption of an almost perfect future e.g. growth will continue, low inflation/interest rates will continue and lending (roll-overs) will continue. Look at Turkey for an example of the assumption made two years ago by lenders now longer holding true.
Cyclically adjusted price earnings ratio
On the first condition (high asset markets) we can cite the evidence of the cyclically adjusted price earnings ratio (share price relative to average earnings per shares measured over ten years).
For the USA this is now 34.7 (the historical average is 16.2). It has never been this high -except on one occasion.
Today the market is hig
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