Let’s have a quick discussion about the claims of the “perma-bears” in the market. Is the market extremely overvalued and likely to fall into a bear market?
The difficult answer is that the market can be extremely overvalued (and probably is) and still not reverse into a 2008-style recessionary decline.
There are many ways to measure value, but they tend to suffer from similar problems. For instance, both the price-to-earnings (P/E) ratio and the Shiller Cyclically Adjusted Price/Earnings (CAPE) ratio are extremely high right now. You can see how high the CAPE is in the next image.
On the surface, this seems worrisome because of the apparent relationship between high valuations and recessions. However, there are big issues with these measures once you dig in below the surface.
CAPE Ratio: Multpl.com
One problem with value measures like P/E and CAPE is that they use past data compared to current prices. The CAPE is the most distorted because it uses a 10-year average of historical earnings, which includes the disastrous 2007-2010 period, to justify today’s prices.
It doesn’t make any sense to suggest that investors shouldn’t pay this much for historical earnings since you can’t buy past earnings anyway.
You can, however, buy future earnings. Or at least you can buy stocks that give you access to what you hope those future earnings will be. Estimates about the future are ultimately what is driving value ratios higher. Based on price movement, investors think that earnings will continue to rise in the future and justify their decision to buy stock.
To be clear, the bears aren’t completely irrational. Expected growth rates are probably unrealistically high. So, how can we justify our position that a bear market is very unlikely this year?
Bear Markets Require Negative Growth
True bear markets almost always require a contraction (negative growth) in the economy, or at least profit growth in the stock market needs to be negative.
As you can see in the next chart, the last big corrections in the S&P 500 (yellow) in 2008, 2012 and 2015 were preceded or accompanied by a decline in the earnings (blue) of the S&P 500.
The 2012 bear market had a choppier relationship with declining earnings merely because the Fed was pulling out all the stops to try and keep it levitating.
An earnings contraction is the missing component this time around. Sure, profit growth has been a little sluggish in the third quarter (~3%) compared to the first quarter (13.6%), but current market conditions just don’t seem to justify a long-term negative outlook … yet.
Does all of this mean that the bearish broken clocks won’t be right eventually? No, they will be right at some point, and the further valuations extend, the more likely it will be that the decline will be very large. However, we must maintain a reasonable short-term outlook as well.
Until earnings or economic activity starts to contract, the likelihood of a true bear market is low. Short-term corrections (-3% to -7%), however, are not unlikely, and we will continue to be watchful for signs that one may kick off before the end of the year.
InvestorPlace advisers John Jagerson and S. Wade Hansen, both Chartered Market Technician (CMT) designees, are co-founders of LearningMarkets.com, as well as the co-editors of SlingShot Trader, a trading service designed to help you make options profits by trading the news. Get in on the next SlingShot Trader trade and get 1 free month today by clicking here.