How Likely Are Market Crashes?
It is well known that equities are subject to both booms and busts, testing the discipline of most investors and leading legendary investor Warren Buffett to conclude: “Investing is simple, but not easy.” Perhaps the best example of the boom-and-bust nature of equity markets is the late 1990s. From January 1995 through February 2000, the S&P 500 boomed, returning 25.8% per year. By the end of the period, the ShillerCAPE 10 had reached 42.2, producing an earnings yield of just 2.4%. The CAPE 10 earnings yield has been as good a predictor as we have of future equity returns. At the time, the yield on 10-year Treasury Inflation-Protected Securities was in excess of 4%. In other words, the expected real return to equities was almost 2 percentage points less than the riskless real return on TIPS. If anything is a sign of a bubble, that is the leading candidate. Then, from March 2000 through September 2002, the S&P 500“busted,” producing a cumulative loss of 38.3%.
Another boom and bust was experienced from October 2002 through October 2007 when the S&P 500 returned 15.5% per year. That boom, which pushed the CAPE 10 to 27.3, producing an earnings yield of 3.6% (just 1.5 percentage points above that of the yield on 10-year TIPS), ended in a bust that saw the S&P 500 lose a total of 51.0% from November 2007 through February 2009.
The next boom and bust occurred a decade later. After returning 26.1% a year from 2019 through 2021, producing a total return of just over 100% in three years—a boom that pushed the CAPE 10 to 38.3 (an earnings yield of just 2.6%)—from January through September 2022, the S&P 500 lost 23.9%.
The historical data demonstrates that extremes in the right tail of the return distribution (caused by rising valuations) can portend sharp reversals and painful performance downturns.