How Bad Will the Next Stock Crash Be and When Will it Arrive?

Beyond Buy-and-Hold #108

In the days before Buy-and-Hold, investing analysts tried to predict short-term changes in stock prices. The idea was to buy low and sell high and to do that investors needed to know whether stock prices were headed higher or lower. So lots of people took guesses and tried to make their guesses sound smart.

Buy-and-Holders root their strategies in the academic research. The research says that short-term timing doesn’t work. So most of today’s investors don’t believe that guessing where stock prices are headed is possible.

Unfortunately, the Buy-and-Holders threw the baby out with the bathwater. There really is research showing that short-term timing doesn’t work. So they were wise to give up on the idea of predicting short-term price changes. But there is now a mountain of research showing that long-term timing ALWAYS works. So Valuation-Informed Indexers have brought back the practice of predicting returns. The difference from the pre-Buy-and-Hold days is that they predict only long-term developments and never short-term ones.

A 65% decline in stocks is coming based on the P/E10 level

Some find this frustrating. I say (based on the academic research) that we will see a 65 percent price drop sometime over the next five years. There has never yet in U.S. history been a time when we went to a P/E10 level of 25 and did not drop to a P/E10 level of 8 in the aftermath of the economic crisis always brought on by that amount of overvaluation. A P/E10 of 8 is a price drop of close to 65 percent from where we stand today. So I feel confident warning stock investors that they need to plan for the possibility.

But when is this price crash coming? If I don’t give specifics, investors feel that they cannot plan. Most investors think of “planning” as making moves to miss the price crash or to benefit from its aftermath.

I don’t think about it that way. My take is that we cannot know the details. But we do know that the risk of stock investing is much greater today than it is in ordinary times. Investors should lower their stock allocations in deference to the added risk. And that’s all they should do. Trying to guess precisely when the next price crash will come or how deep it will be is a stupid parlor game that smart investors should avoid playing.

Still, for purposes of this column…

I am going to play the stupid parlor game!

People really do want to know the answer to this one. So I feel that I should try to make tentative predictions. Please understand that that’s the best I can do. The research tells us that precise predictions don’t work and that those who try to do what I will try to do in this column usually end up looking like fools.

The most likely price drop is one of 65 percent. People will act shocked and amazed when it comes. They will call it a “black swan.” It really will be nothing of the kind. A 65 percent price drop is what you should expect. We have seen such a price drop in the wake of every earlier bull market. The surprise would be if we did not see a 65 percent price drop.

My guess is that there is an 80 percent chance that we will see a price drop of greater than 50 percent. The odds are 70 percent that we will see a price drop of greater than 60 percent. And there are six chances in ten that we will see a price crash of more than 70 percent.

When?

I put the odds of seeing the crash within the next five years at 80 percent. I put the odds of seeing in within four years at 75 percent. I put the odds of seeing it within three years at 65 percent. And I put the odds of seeing it within two years at 50 percent.

There’s a good chance that we still have two price crashes ahead of us. One crash could bring us down to fair-level prices or a bit below. Then, after the passage of another year or two, we could see the price drop taking us down to a P/E10 level of 8 or lower (one-half of fair value).

I think that there’s probably a greater than 50 percent chance that the crash will come in two stages. But there is also a greater than 50 percent chance that the second stage of the crash will follow within two years of the first stage.

The most important question is…

Will we end up in the Second Great Depression?

That’s about a 50/50 bet at this point, in my assessment. I see little chance anymore that we will as a society work up the courage to teach investors what they need to know for us to avoid the price crashes that threaten to put us in the Second Great Depression.

However, if we act quickly to get the word out following the next crash, I think it may be possible to bring on a new economic growth surge that would prevent us from falling into the Second Great Depression. I think we will need to see policymakers get serious about teaching investors what they need to know within six months of the next crash for us to retain realistic hopes of seeing that happy outcome.

Please feel free to call me a fool if I am shown to have gotten it all wrong! I deserve the catcalls for making an attempt at giving effective short-term predictions, something I generally view as next to impossible to pull off.

Rob Bennett has written an article titled The Bull Market Caused the Economic Crisis. His bio is here.

( Photo from Flickr by Helico )

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