Why a stock market crash may be imminent

A natural question at the start of a new year is whether the stock markets will keep climbing. The S&P 500 Index has enjoyed a particularly good run over the past 15 years, having recently broken through 6,000; it was as low as 732 in early 2009.

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Now is the time for retirees and all investors to think about whether we are in for a correction, or even a crash.

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To address this question, I charted price/earnings ratios going back to 1928. High P/E ratios are an indicator that a stock is getting pricey. It is like the tension on an elastic band. The higher the P/E ratio, the tighter the band and the more likely it will snap.

For the S&P 500 Index as a whole, the P/E ratio used to trade between 10 and 20, even in 1929 on the eve of the most famous market crash in history. After 1990 though, higher P/E ratios started to become almost commonplace. So did market crashes. The first one occurred in March, 2000, when the dot-com bubble burst. The second one took place in September, 2008, triggered by the bankruptcy of Lehman Brothers.

Currently the P/E ratio for the S&P 500 stands at just above 30. This level has been reached only once before while stocks were still rising: toward the end of the dot-com bubble – and we know how that ended. (While it appears P/E ratios were very high in 2005-09, all the high P/E ratios occurred after the crash and were the result of collapsing earnings, not rising stock prices. If the P/E ratios in the 12 months after September, 2008, are ignored, the average P/E ratio in this period was just 20.)

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Can the S&P 500 go even higher? Yes, but something unprecedented would have to happen. A P/E ratio of 30 has never been sustainable in the past. If it fell to 20 and if current earnings remain unchanged, the S&P 500 Index would drop to 4,000.

Even though Canadian markets are not as overextended, they would suffer damage as well.

Frederick Vettese is former chief actuary of Morneau Shepell and author of the PERC retirement calculator (perc-pro.ca)