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How Long Might the Next Bear Market Last?

Many investors worry that the stock market’s current overvaluation means that the next bear market—whenever it begins—will be a long and deep one. It might surprise and comfort investors, though, to learn that there is little historical correlation between stock valuations and the length and duration of bear markets. At the beginning of that longest bear market, the cyclically adjusted price/earnings ratio, or CAPE—the one made famous by Yale University finance professor and Nobel laureate Robert Shiller that is based on average inflation-adjusted earnings over the trailing decade—stood at 16.45. That is below the CAPE ratio’s long-term average, suggesting an undervalued stock market.

At the beginning of the shortest bear market, in contrast, the CAPE ratio was more than twice as high, at 38.3. That reading was higher than all prior readings back to 1871, according to data from Prof. Shiller, suggesting a severely overvalued market. And yet the ensuing bear market lasted less than two months. The unreliability of forecasting the length of bear markets based on valuations can’t be traced to some defect in the CAPE ratio. Each of the seven other well-known and highly regarded valuation indicators I studied were equally unreliable. These seven, each with impressive long-term forecasting records in their own right and about which I’ve written before, are the ratios of price to earnings, price to sales and price to book value, the dividend yield, the Buffett indicator (the stock market’s total market cap divided by gross domestic product), the “Q” ratio (calculated by dividing market value by the replacement cost of corporate assets), and the average investor’s equity allocation. 

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None of this means valuations don’t matter. Indeed, each of these eight indicators has historically been correlated in a statistically significant way with the stock market’s subsequent 10-year return. The universal message of all eight currently is that the stock market’s prospects over the next decade are at best mediocre—if not much worse. That’s because all eight currently are more overvalued than at least 90% of the time in U.S. history. .  With the benefit of hindsight, we today tell ourselves that there was little doubt that the government’s and the Fed’s actions would succeed in creating a new bull market. But with the benefit of Prof. Shiller’s focus on narratives, we instead realize how fragile the bull market is and how vulnerable it is to changes in the way the winds are blowing among investors.

So even though the stock market today is overvalued according to any of a number of time-tested indicators, the next bear market—whenever it occurs—may or may not be particularly long or severe. It will depend in no small part on investor psychology. And that may or may not be a source of solace.




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