Stocks down 40% would pop this market bubble — but slow deflation is more likely than a quick crash

 

 

The U.S. market’s current bull run will end with a whimper, not a bang

The probability of a U.S. stock-market crash is below average right now. That’s according to the “froth forecasts” compiled by State Street Associates, which are based on research by Harvard University professor Robin Greenwood. The probability of a 40% decline at some point over the next two years — the operational definition of a crash that they use — is calculated to be 18%, lower than the trailing five-year average of forecast probability, at 26%.

The same conclusion applies to the high-tech sector, which has produced some of the most dynamic returns of late and been the focus of many of the bubble predictions. State Street calculates that the probability of a crash in that sector is four percentage points lower than the five-year average.

Bubble predictions tell us more about the analyst making the prediction than the objective probabilities of a crash.

— Will Goetzmann, Yale University
It’s worth emphasizing these below-average probabilities because of the recent uptick in bubble predictions on Wall Street. Most of those making these predictions are not working with a precise definition of a bubble, however, and have no rigorous criteria for what constitutes the deflation of a bubble — a crash, in other words. Absent these criteria and definitions, according to Yale University’s Will Goetzmann, bubble predictions tell us more about the analyst making the prediction than the objective probabilities of a crash.

Both Greenwood’s and State Street’s crash probabilities are a function of the U.S. stock market’s performance over the past two years. As past performance increases, so does the probability of a subsequent crash. When the trailing two-year price run-up is 100%, for example, the probability of a subsequent crash is close to 50%. When the trailing price run-up is 150%, “a crash is nearly certain.”

The S&P 500 SPX over the past two years has produced a cumulative (unannualized) return of 48.9%, far short of the price run-ups that are associated with a significantly heightened probability of a crash.

Market concentration
I want to specifically address one of the arguments made by those who think a bubble is imminent: the huge return differential between the cap-weighted S&P 500 and the equal-weight version. So far this year the cap-weighted index (the one quoted in the financial press every day) has outperformed the equal-weight version by more than 10 percentage points. Last year, the cap-weighted version’s outperformance was more than 12 percentage points.

This difference suggests that the cap-weighted version’s performance has become increasingly reliant on the largest stocks in the index, and many analysts believe such concentration is a sign of an unhealthy market that is especially vulnerable to a decline. But my analysis of data since 1970 does not support this.

What I found is summarized in the chart above. The blue line plots the degree to which the cap-weighted S&P 500 outperformed the equal-weight benchmark over the trailing two years. The red columns represent the cap-weighted S&P 500’s performance over the subsequent two years. Be my guest trying to find a consistent pattern between the two series; my PC’s statistical package says there isn’t one at the 95% confidence level that statisticians often use when assessing whether a pattern is genuine. 

None of this means that the U.S. stock market doesn’t face challenges. For one, it is extremely overvalued. But there are many ways for the market to work off overvaluation, and a crash is just one. Based on the State Street Froth Forecasts, it’s a good bet that the market will overcome its overvaluation in one of those other ways — such as a long period of mediocre performance.