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History says we are due for a crash (Part II)

Note:  Outside of the weekly newsletter, I do not do much blogging, but occasionally there is something I think there is worth throwing out for general consumption (see my last public rant here).


Stocks are expensive.  We have all heard the arguments about long term value metrics with good track records, such as the CAPE ratio and Tobin's Q, but from a very basic P/E standpoint, stocks are at extreme valuations.

However, at a P/E ratio just above 20, most analysts/pundits would argue that we are only slightly above the historical average.  

Unfortunately, the "historical average" of P/Es is almost meaningless for two reasons.  First, P/E ratios are mostly noise. and not very predictive.  They are valuable and predictive when at extremes.  Second, the context matters.  In March of 2009, the 12 month trailing P/E on the S&P 500 was over 100.  Did that mean that stocks were ridiculously expensive?  To the contrary, equities were extraordinarily cheap.  The trailing 12 months of earnings were extremely depressed.  It made sense to be paying up in anticipation of a rebound.

That is precisely what makes the current market environment different.  We are at record earnings (or within 5% of record earnings), and near record stock prices.  Rarely in history have markets been willing to pay high multiples for record earnings and record prices.  Every time they have, it has ended in disaster.

When I first ran these numbers last summer, the P/E on the S&P 500 was approaching 19.  Only three times in history have investors been willing to pay above that amount for record earnings.

The first was in September of 1929.  Stocks did not break even for nearly 25 years.

The second was in 1964.  There was no imminent crash, but the 1973-74 crash saw stocks cut in half, falling over 20% below the 1964 levels.  It took nearly 11 years from 1964s high valuations to break even.  From 1964 prices, even with dividends, stocks lagged T-Notes for over 10 years.

The third valuation peak began in 1996 (though stocks remained generally expensive through 2004).  Stocks saw 50% declines twice over the next 13 years, and the 2009 lows managed to take out prices first seen in 1996.  It took over 12 years from 1996's high valuations before stocks set and held new highs.  Even with dividends, stocks lagged T-notes for fifteen years.

In each of these cases, once investors have been willing to pay this much for stocks, it has paid to walk away from the stock market for a decade or more.

Let me rephrase: under these historical analogies, we should not be expecting "below average" returns over the next ten years,  as some of the more pessimistic analysts have been claiming.  We should be expecting no returns.

Then again, maybe it is different this time.  Even if history repeats itself, acting on these concerns can be a test of patience.  Though stocks crashed immediately in 1929, they climbed for 9 years before crashing after 1964, and valuations doubled from 1996 levels before the tech bubble collapsed.  In that regard, valuations are difficult timing tools, but if investors truly have long term time horizons, these lessons from history should not be ignored.

History says we are due for a crash. 


With stocks setting new highs on an almost daily basis, companies earning record amounts of money and unemployment falling, there is a broad sense of optimism in the market.  That should not be news to anybody.

However, with stocks setting new highs on an almost daily basis in a low volatility environment on light volume without facing a 10% correction, there are also a lot of people who are quite anxious.  To anyone who reads/watches financial media, this too should not be news.

There are also the perma-bears, but let’s not give them any attention.

Then there is a large moderate voice who have, perhaps rightly, given up “trying to predict the future” (even though they do it anyway).  This group really does have the best interest of investors in mind – largely advocating for some variety of low cost, passive (for the most part) index investing.  This group is pretty noble, admitting that they are never going to field the most interesting ideas in the room, but will put their commoditized approach to use for the betterment of their clients.

I am a big fan of this group.  Perhaps my favorite CNBC contributor, Josh Brown (@reformedbroker) is often the most moderate/rational voice in the networks’ hexa- and octo-boxes of talking heads.

I don’t want to single Mr. Brown out, but a tweet he sent out a week or so ago inspired me to hit on a topic that has been weighing on my mind lately.


Anyone who has been following my father’s and my work knows that we have been extremely bullish for the past six years.  I admit to getting a little anxious early in 2013, but for the most part I have advocated for unrestrained optimism (that includes at the darkest moments of the recession, throughout the European crisis, etc).

I have long been one of those scoffing at the crowd calling for a correction (readers know why I have not been in the “correction is due camp”).  But at this stage in the rally, I think that openly mocking those calling for a crash shows quite a bit of hubris, and may be instilling investors with excessive confidence (even when you want investors to be level headed).

I particularly take offense because I am now part of the group that doesn’t think this run will end well.

It is easy to say that stocks will crash one day.  That is a given. 

This time, however, market history suggests this bull market will end with a crash and it is not too early to start preparing.

From the 2009 low through the end of the first half of 2014, the Dow advanced 157% over 1939 days.  (I am using the Dow, but Robert Shiller’s monthly S&P data yields the same result.)

Maintaining gains that strong  is a rare feat.

So rare, in fact, that it has only happened during four other periods in U.S. market history: 1928-29, 1936-37, 1987, and 1998-2000.  Each of those markets ended in a crash of at least 35%.

Crash analogies like this one are met with some derision.  When predicting a future crash, the counterargument is often that, while there may be a crash, trying to predict the top is futile, as the market could run far from current levels (see Greenspan and "irrational exuberance"). 

This is true, but in each of the previous historical analogues, the crash has taken out not only the late stage gains, but the levels we see today as well, with a minimum drawdown of 20%.  On top of that, the quickest recovery from reaching what I will call a “warning” pace was 707 days in 1987.  The other three instances took more than a decade to recover.


Warning Price

Cyclical Peak

Eventual Low

Drawdown from Warning

Drawdown from High

Upside Before Decline





































 On the other hand, markets have typically had a nice run after a similar pace had been set, gaining between 16% and 60% before peaking.  That means neither Dow 19,000 nor Dow 26,000 is outside of the historical realm of probability. 

Take away from this what you may, but ponder this point:  every time the market has gone up this far this fast, it would have paid to liquidate equities and walk away for two years. In three out of four similar scenarios, it would have paid to walk away for ten.

Final note:  Nothing in this should be taken as investment advice or an offer to sell anything.  Talk to your qualified personal investment advisor before making any investment decisions.


Since 1977 Drach Market Research has been devoted to providing investors the use of easily understood statistical applications to aid in portfolio management.  Founded by Robert F. Drach and continued by his son, Robert B. Drach, the Drach Market Research weekly newsletter has been published without interruption since our inception, guiding investors over the course of three decades, multiple market crashes, six Presidencies and six Federal Reserve chairs.

Robert F. Drach spent over 30 years as a regularly scheduled Market Monitor on PBSs Nightly Business Report.  His educational model portfolio was a feature of the website from 1995-2013, and can now be followed right here.

Mr. Drach was also the co-author of the High-Return Low-Risk Investment book series, copies of which occasionally surface on Amazon.

In anddition to writing the Drach Market Research weekly newsletter, Robert B. Drach runs an asset management firm, building on the equity strategies pioneered by his father, and serves as an adjunct university finance instructor.

Please feel free to offer up your feedback, particularly if there is anything you would like us to add to the site.


Robert F. Drach, 1944-2012

We are sad to announce that Robert F. Drach, founder of Drach Market Research and renowned financial analyst, author, and television commentator, passed away on December 18 after a battle with cancer.

Mr. Drach's work was a steady data-driven voice amid the increasing cacophony of financial analysis.  While others were trying to get ahead of the curve, Bob hung back, relying on what he believed to be perpetual truths in the stock market.  For him, there was never a "new normal," just the same market dynamics that existed since he began trading stocks as a teenager.

He will be remembered for some of his boldest calls.  Following the 1987 crash, Bob appeared on the Nightly Business Report and called a bottom amidst market panic.  His newsletter portfolio avoided the collapse of the tech bubble, and most recently he called for for market optimism in the darkest days of the Great Recession.

He will also be remembered as a wonderful husband, father, and grandfather, who always put his family first.

Mr. Drach's work will live on.  Over the past several years, Mr. Drach's work featured significant contributions from his son, Robert B. Drach.   Robert began working alongside his father by stuffing envelopes in elementary school.  As a teenager, he converted much of his father's work from paper to Excel spreadsheets (the rest is still done on yellow pads).  As a graduate student, Robert worked on methods to expand on Bob's investment framework, culminating in a global equity strategy using exchange traded funds.  And for over six years as an asset manager, Robert has continued to build on, refine and implement his father's investment models. 

Robert has assumed the authorship of both Mr. Drach's newsletter and daily commentary.  While he tries to capture the spirit of his father, many readers have undoubtedly noticed the new voice he lends to these pages.

Bob Drach will be missed, but his insights into the market will never fade.