During A Price Crash, It Helps To Know How Far Prices Will Fall

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Stocks are today priced for a crash. They have been priced for a crash for a long, long time. So, if you want to ignore the warning sign that today’s CAPE value is sending out, I can’t entirely blame you. You certainly are in good company.

A Price Crash

Still, one day there will be a crash. It could be that it will be super soon. It could be that it will not be for some time yet. But if you believe that Robert Shiller’s Nobel-prize-winning research is legitimate research (I do), then you have to accept that irrational exuberance is a real thing and that today’s stock price is to a large extent not backed by economic realities. So there’s certainly a chance that we are going to see a price crash.

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When we do, lots of people will be panicking. The time for thinking through how to respond to a crash is now, when it is possible to remain calm enough to develop a halfway rational response plan. The most important thing that an investor living through a crash needs to know is – How far are prices likely to fall?

The most important thing to know re that question is that it is not possible to say with precision how far prices will fall. We had a major crash in late 2008 and Shiller himself got an important part of the story wrong. Shiller advised investors not to get back into stocks until the CAPE level dropped below 10. That advice made a lot of sense. Prices crash when investor psychology flips from being primarily hopeful to being primarily fearful. Shiller’s thought that hope would not again become dominant over fear was in line with 138 years of market history. The usual rule is that the CAPE value falls to 8 at the completion of a full bull/bear cycle.

Shiller was wrong. The lowest CAPE value we saw was 13. Investors who waited for 10 to get back into stocks are still waiting.

Shiller’s mistake was not to appreciate that, while we now have over 150 years of market history to inform us as to how investors respond to stock price changes, there were only four bull/bear cycles completed in those 150 years. So we have not yet seen all of the possibilities play out. It’s not realistic to conclude that we will not see some new scenario play out when the next price crash arrives. Our ability to predict the future is limited.

But it is not non-existent. We did see prices fall to a bit below the fair-value CAPE of 17 in the wake of the 2008 crash. That’s the key psychological barrier. When investors create a bull market, their aim is to obtain something for nothing. There’s all the difference in the world between pricing the market at something higher than what it is worth and pricing the market at something lower than what it is worth. There was a psychology shift in late 2008 and early 2009. It did not produce prices as low as what the historical record suggested was likely. But there was a break.

Repeating The History

Is it possible that we will see a repeat of what happened in 2008 this time?

I suppose that it is possible. But I don’t think it is at all likely. First of all, the 2008 experience is the first time in which the end of a bull/bear cycle did not bring the CAPE value all the way down to 8. Something like that may happen again someday. But given that we have only seen that scenario play out one time in U.S. stock market history, it should certainly be viewed as a long-shot possibility.

The more likely scenario is that, once investor psychology has broken, we will see the CAPE value fall all the way down to 8. That’s a scary thought, But that’s what we saw in the early years of the 20th Century and in the Great Depression and in the 1970s. As horrible as it is to contemplate, that’s the most likely scenario once investor psychology has been damaged sufficiently to bring on a price drop large enough to be considered a crash.

It’s important to keep in mind that there is no rule for how long it could take for the CAPE to fall to 8. It could happen quickly. I believe that it is more likely that the fall will take place in stages. A drop to the low 20s will scare most stock investors. Once we have hit those sorts of levels, there will be many who will come to believe that the worst of the crash is behind us and who will buy enough stocks in response to that belief to stabilize prices.

Stocks will certainly be priced better then than they are now. It would make sense for investors going with low stock allocations today to begin to increase them when the CAPE value drops below 20. But such purchases should only be made with an appreciation that the long-term trend for the CAPE value may well remain downward until we have hit 8 or something close to it.

Memories of the 2008 pattern may cause the bear market to stall once the CAPE has dropped below 13. People will be expecting the Fed to step in and save the day once again and, indeed, pressures on the Fed to take action will probably be strong. But of course the FED cannot always save the day. If it could, bull markets could last forever. In all likelihood, prices that stall at 13 will continue heading downward after the passage of some time. It’s not possible to say how much time will pass before the downward movement begins again. But any decisions at that stage of the price drop should be made with an appreciation that further downward movement is possible and probably even likely.

It is my hope that the next price crash will cause a higher percentage of investors to open its mind to the significance of Shiller’s research and to develop more valuation-informed strategies. If that happens, all bets are off re the thought that the CAPE will eventually drop to 8. There is no rational case for that happening. A CAPE of 8 is as crazy as a CAPE of 32. My hope is that a drop below 13 will be scary enough for us all to educate ourselves to the realities sufficiently so that we will never again see CAPE values of either 8 or 32.

Rob’s bio is here.