Nothing lasts forever, and that includes bull markets in stocks. The current one began its tenth year in March, and investors should be on the lookout for signs that the next, long overdue, bear market is imminent. Nicholas Colas, co-founder of DataTrek Research, offer three scenarios for how the next extended downturn is likely to unfold, as reported by MarketWatch. These scenarios are: a fast crash, a lengthy decline, or a recession-induced "price reset." (For more, see also: Stocks On 'Collision Course With Disaster,' Face 40% Drop.)
This scenario would be similar to the 1987 stock market crash, in which there was a sudden, violent downdraft in stock prices, with the worst of confined to a single trading day. Based on his analysis of stock and bond market valuations in both 1987 and today, Colas figures that a repeat of 1987 would involve a decline in the current forward P/E ratio on the S&P 500 Index (SPX) to about 15.4 times earnings. That, he calculates, would send the index down to a value of 2,187, or 17.9% below the close on April 12. The 1987 crash was followed by a fast rebound, and stocks were up for the year, MarketWatch notes.
Under the second scenario, the cyclically-adjusted P/E ratio (or CAPE ratio) for the S&P 500 reverts to its long-term mean since the 1880s, which is a bit more than half today's reading. Colas calculates that this would send the index way down to a value of 1,646, or 38.2% below the April 12 close. As unsettling as that prospect might be, it would place the S&P 500 where it was in September 2013, which nonetheless was above the tops in 2007 and 2000, Colas tells MarketWatch.
He predicts that this unwinding of valuations would take between 12 and 18 months. There have been seven bear market declines of 38.2% or more since 1928, per Yardeni Research Inc., including the bear market of 2007-09 in which the S&P 500 dropped by 56.8% over the course of 517 days. Since 1928, Yardeni counts ten bear markets that lasted 360 days or more.
Recession-Induced "Price Reset"
This is the most likely scenario in Colas' opinion, based on the flattening of the yield curve, which normally is an early warning signal of an impending recession. Analysis by DataTrek indicates that recessions typically reduce corporate earnings by about 20% to 30%, per MarketWatch. Assuming that the valuation multiple for the S&P 500 remains unchanged, Colas estimates that, if investors start to believe that a recession is coming within the next two years, this dynamic would send the index down to about 1,941, or 27.1% below the April 12 close. Of course, if valuations also are revised downwards, the loss will be even greater.
Financial columnist Mark Hulbert has cited research indicating that low volatility stocks often outperform the market. He also recommends some stocks that meet this profile. (For more, see also: 10 Low Volatility Stocks for Wild Markets.)
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