By Henry Ma, Julex Capital Management
As the stock markets continue setting records day after day, many investors are becoming more and more concerned about the potential over-valuation and a possible market correction. The widely-followed cyclically-adjusted price-earnings ratio (Shiller PE) reached 31.2, almost twice as much as the historical average of 16.8. While market valuation may not be a good timing indicator (see If Jeremy Grantham Has a Changing Heart on Value Investing, Should You?), does it have any impact on the severity of a bear market when it happens?
Table 1: Historical Bear Markets
|Time||Duration||Trigger events||Recession Period||Loss||Starting Shiller PE|
|Sept. 1929 – Jun. 1932||34 months||Great Depression||43 months||86.10%||31.48|
|May 1946 – Jun 1949||37 months||Recession after WWII||11 months||29.60%||16.01|
|Dec. 1961 – Jun 1962||6 months||Bay of Pigs Attack and Cuban Missile Crisis||No recession||28.00%||22.04|
|Nov. 1968 – May 1970||18 months||Recession, high inflation, assassination and riots||11 months||36.10%||22.20|
|Jan. 1973 – Oct. 1974||21 months||Arab oil embargo, lengthy recession and high inflation||16 months||48.00%||18.71|
|Nov. 1980 – Aug. 1982||21 months||Fed’s rate hikes and stagflation||16 months||27.80%||9.65|
|Aug. 1987 – Dec. 1987||3 months||Black Monday crash after a lengthy bull run||No recession||33.50%||18.33|
|Mar. 2000 – Oct. 2002||30 months||Dot-com bubble burst||8 months||49.10%||43.22|
|Oct. 2007 – Mar. 2009||17 months||Subprime crisis after housing bubble burst||18 months||56.40%||27.32|
Data Source: CNBC, NBER and Shiller
To answer the question, I collected some historical data on the nine bear markets since 1928 and summarized them in Table 1. There are three interesting observations:
- Three of the four worst bear markets were preceded by high valuation. Among the four worst bear markets with over 40% losses, three of them including the Great Depression in 1929, dot-com bubble in 2000 and subprime crisis in 2007 started with somewhat extreme market valuation. The only exception is the 1973 bear market caused by Arab oil embargo and subsequent recession, but it had an above-average PE to start with as well.
- Three of the four worst bear markets coincided with lengthy recessions. The bear markets of 1929, 1973 and 2007 were accompanied by long recession periods. The perfect example is 1929 bear market, when the three-year-long depression drove the market down by 86%. The exception is 2000 bear market, which was mainly caused by the dot-com bubble burst despite a mild recession in 2001.
- The two bear markets without economic recessions were short-lived. The two shortest bear markets were caused by geopolitical events like Bay of Pigs Invasion in 1961 or market disfunction like Black Monday crash in 1987. Both occurred during the periods of economic expansion.
Historically, the worst bear markets happened amid extreme market valuation or lengthy economic recession, or both. After eight years of economic expansion, the US economy is close to the late stage of the current boom cycle. The current high valuation is certainly a cause for concern. While it is hard to predict exactly when the bear market will happen, high valuation, together with a possible economic recession will likely make the bear market more severe when it finally materializes.
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