Since March of 2009 the stock market has been on a bull run like never before. The very fact that we have experienced a 9 year rally has some folks asking if we are due for a correction. This past February we experienced a 10% correction that had many convinced it was the start of something bigger. However, the market has mostly recovered since then and many folks are back in market euphoria.
I personally believe that within 5 years we are going to have a major market correction. It could be much sooner, but I feel confident in saying it will happen within 60 months. Here’s why:
- The Buffett Indicator– Named after the most famous investor of at least our time, Warren Buffett, this indicator measures the total market capitalization against the US GDP. Buffett has stated that this is his favorite indicator to measure if the market is over or under valued. It’s pretty simple- anytime the ratio of the total market is less than 75% of GDP, the market is under-valued. If it’s between 75-100%- the market is fairly valued. If it goes above 100 it is starting to get over-valued. As of July 10th, 2018 the ratio is at 145.9%! This ratio is also known as the Wilshire to GDP ratio since the Wilshire 5000 basically represents the total market cap. If you look at the chart, which is pictured above, you’ll see that it has been pretty accurate at predicting market corrections.
- Shiller P/E– Robert Shiller is a professor at Yale and he invented this ratio. It is a cyclically adjusted P/E ratio for the S&P 500 which he discusses in his book, Irrational Exuberance. You take the earnings of the S&P 500 companies over the past 10 years and adjust for inflation using CPI. The Shiller P/E equals the ratio of the price of the S&P Index over the past 10 years average earnings (adjusted for inflation). The average P/E ratio is around 16, so anytime it gets above that it is an indication that the market is getting over-valued. As of July 10th, 2018 the Shiller P/E ratio is 32.3.
- Flattening Yield Curve– The yield curve I am talking about is the 2 year Treasury compared to the 10 year Treasury. The gap between the two has been getting more narrow or “flattening” and if the 2 year yield goes above the 10 year yield, a recession is likely coming. Typically, when it comes to bonds the longer the date to maturity, the higher the yield. Think about it, doesn’t it make sense that if you tied your money up for 10 years you would expect a higher return than if you only tied your money up for 2 years? If the 2 year Treasury yield goes above the 10 year Treasury, that is known as yield curve inversion and almost always indicates a recession is soon coming.
- Rising Interest Rates– As interest rates rise, bonds will become more attractive to investors and many retirees will shift money away from stocks to bonds since bonds are considered very safe. Also, rising interest rates means it is harder for consumers and businesses to borrow money, which means spending could slow down. With that said, interest rates are still very low and we have a ways to go before that will be felt. But the point is, the Federal Reserve has indicated rates are going up, not down.
I have given you 4 indicators that all point to the market being over-valued. With that said, what will actually cause the correction? It could be lots of things! All-out trade war, corporate earnings turning weak, a softening real estate market, war with North Korea… We could speculate all day long as to what the culprit will be. Perhaps it won’t be just one thing, but multiple things. Who knows! The thing I do know is that the market moves in cycles. There are bullish cycles and bearish cycles. We are on a 9 year bull run and there are some proven indicators that say we are way over-heated. I cannot predict when or how, the 5 year prediction is just a guess, but I do believe now is a good time to take profits and be patient!