How Likely Are Market Crashes?
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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.