Is it time to brace for a crash? Price-to-earnings (P/E) ratios for the MSCI World and S&P 500 indexes are above-average. The cyclically adjusted P/E, or CAPE, is at levels seen only twice before: 1929 and 2000. The CBOE’s VIX, which supposedly measures fear, is low. And the CBOE’s SKEW, which claims to measure the probability of a crash, recently hit record highs. But all four metrics have one big thing in common: They aren’t predictive. P/Es can indicate sentiment, but the rest are too convoluted to say anything useful.
Let’s take them in turn. P/Es simply tell you how much investors value future earnings. They regularly gyrate during bull markets as stock prices (P) and earnings (E) evolve. Stocks have historically done fine with high P/Es and low P/Es (both have preceded bad times, too). P/Es can signal euphoric sentiment if they spike quickly, but the recent gradual rise doesn’t qualify.
CAPE, commonly cited in media, doesn’t even signal sentiment. Because it measures stock prices against the last 10 years’ inflation-adjusted earnings, it is 10 times more backward-looking. While everyone points to its elevated levels before 1929, 2000 and 2008, there are plenty of false reads in between. In December 1996, elevated CAPE famously prompted then-Fed head Alan Greenspan to warn of “irrational exuberance” in stocks. But that bull market—history’s longest—ran over three more years, with the MSCI World returning 67%.[i]
Now, many might retort that CAPE isn’t designed to call turning points, but rather, project the next 10 years’ returns—a high CAPE indicating low returns ahead. Which raises the question: Why care now? Even if returns over the next decade are low—something CAPE can’t reliably predict as it doesn’t account for equity supply—what’s to say the next 1, 2, 3 … 6 years aren’t great? (And why in the world would a Fed chairman like Greenspan care about the next decade’s returns in setting policy?) This gauge is famous because of a coincidence: Robert Shiller published a book based on it titled “Irrational Exuberance” right before the tech bubble burst. Since then, it has been above average most of the time and falsely indicated trouble for most of 2003 and 2004. Media likes to try to have this both ways, instilling crash fears when it’s high—only to claim that isn’t the point when crashes don’t come. Don’t fall prey. CAPE is a broken gauge, full stop.
The VIX is no better. It uses S&P 500 options prices to approximate fear and expected volatility. When the VIX is high, it supposedly means surging fear—time to buy. When it’s low, it claims investors are complacent and ignoring risk—time to sell. In reality it doesn’t predict volatility or forward returns. It simply shows what options traders think, a sliver of total investor sentiment. Moreover, even a high VIX doesn’t mean traders think big downside awaits. VIX measures movements’ magnitude—up or down—not direction.
SKEW is just skewed, so skewer it. It claims to show the probability of a huge crash, using statistical mumbo-jumbo we won’t bore you with. Its record-high level of 154.37 on March 17 supposedly means the chance of a crash has never been greater.[ii] But the index’s entire history is full of false signals. Its prior record high of 153.66 last June 28—just as markets were recovering from the Brexit vote—signaled a fantastic time to buy, not sell. Since then, world stocks are up 17%.[iii] The SKEW has regularly breached 140 during this bull market, without an epic crash. During the prior bull market, SKEW peaked at 142.02 on 3/16/06, nearly 19 months before the bull’s October 2007 end and two years before Bear Stearns failed. In the 1990s’ bull, SKEW hit a then-record on 10/6/1998—at the end of a deep correction, another fantastic buying opportunity. From then through the 3/24/2000 peak, world stocks returned 43%.[iv]
Bull markets don’t end because arbitrary indicators dictate death. They end one of two ways: the wall or the wallop. Usually, they end because stocks have climbed all the way up the wall of worry, investors are too euphoric, and future earnings can’t possible meet their astronomical expectations. That’s what happened in 2000 as the dot-com bubble burst, and in the early 1970s when investors were too high on the “Nifty Fifty,” buying “growth at any price.” But sometimes, bull markets get walloped before they finish climbing the wall, when a huge, unseen negative surprise materializes and knocks a few trillion off global GDP. This is what happened in 2008, when an esoteric US accounting rule—FAS 157, or mark-to-market—ultimately forced banks to take nearly $2 trillion in paper losses as firms sold illiquid mortgage-backed assets at firesale prices, causing a wholesale funding freeze that ultimately rendered Lehman Brothers and others insolvent. That, combined with the US government’s erratic response, ended the bull market that began in 2002 well before investors had the chance to get euphoric.
Risks always exist, but we don’t see any wallops presently. Today’s risks are small and widely discussed, not massive and overlooked. As for sentiment, investors are growing more optimistic—as higher P/Es show—but they aren’t euphoric. It takes ample time for warming optimism to boil over into full-blown euphoria. This is a time to own stocks and watch them rise as confidence grows.
[i] Source: FactSet, as of 3/24/2017. MSCI World Index return with net dividends, 12/6/1996 – 9/29/2000.
[ii] Source: Chicago Board of Options Exchange, Skew Index Level on 3/17/2017.
[iii] Ibid. MSCI World Index return with net dividends, 6/28/2016 – 3/23/2017.
[iv] Ibid. 10/6/1998 – 9/29/2000.