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Sunday, April 5, 2020

Crash 2020 - Where's the Bottom?

Stock Market Collapse
An Avalanche Waiting to Happen

As the market crashes, a big question is where does it stop falling?

Using standard methods to value the stock market we find that in the year leading up to the current downturn the stock market was extremely overvalued - "an avalanche waiting to happen".

We find the "Dow Jones Industrial Avg." could easily fall over 50% from its top of roughly 30,000 to as low as 15,000 - possibly lower.

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The most respected valuation methods available suggest the current market downturn could very likely end with the S&P-500 in the range of 1500 to 2000 vs. it's current value around 2500.  That would represent an additional 20% to 40% decline in the the S&P-500.  The equivalent Dow values would be around 14,000 to 18,000.

However, that range would be the long term "median" or "average" value.  Looking at previous downturns such as the 2007-2009 crash, we see the S&P-500 could overshoot down as low as 1130 (or Dow at 12,000) to reach a bottom before rising again.

The economy will be in a worse recession than the 2007-2012 "Great Recession" with unemployment rising to 15% and taking a very long time to recover.

Nothing in here is intended to be investment advice or a recommendation on whether to buy or sell securities of any form.

Stock Market - Crashes and "Rallies"

Market downturns can take over 3 years to go from top to bottom with lots of 'rallies' in between.  The "Housing Bubble" crash of 2007-2009 took a relatively short 17 months with at least 6 rallies along the way - 3 rallies of more than a month - click on chart below to enlarge:

2007-2009 Market crash.  Each bar is a week.
Note 6 rallies with 3 of those rallies lasting 1 or 2 months.
We are currently in a "rally" retracing 50% of the previous drop.  That is a standard type of rally in a bear market - 50% "retracement" is the norm.  While nothing is certain, it is hard to believe it will persist with the widespread economic devastation that is already starting to manifest itself.  More "normal" is a "testing of the previous lows" as the standard market jargon has it.

Each bar is one trading day.  Note that the current rally has only lasted 13 days - less than 3 weeks.
As we saw in a previous chart, rallies can last 5-8 weeks before the downward trend resumes.
According to the President of the Wells-Fargo Investment Institute, since 1929, there have been 13 "waterfall" market crashes like the one in March. Each one was followed by a 50% "rally" (i.e., a retracement of lost value) like the one we see now in the above chart.  Every single one of those rallies failed and the downward trend resumed.  In 9 failures, the market reverse broke through new lows, in 3 the market hit the previous low and bounced off of that, and in 1 rally failure, the market stopped just short of hitting the previous low.  More here:

With unemployment predicted to be 18.8% in California by May, with auto sales projected to be under 12 million in 2020 vs 17 million in 2019, it is hard to see how this gets better in less than 2 years.

Economists' Views:

Dr. Nouriel Roubini of NYU accurately predicted the 2007 crash several months before it actually started.  His view is that the coming downturn will be worse than the "Great Recession" of 2009 when the market fell 58%.  Dr. Roubini interviewed here

"'It's way worse than the Great Depression,' says KPMG economist"

We expect this to be on par with the "Great Recession....We expect a U-shaped recovery but it could be far worse." - S&P Global U.S. Chief Economist Beth Ann Bovino:

'More than 45 million Americans,' could lose their jobs in a possible 'worst case scenario' (= 30% unemployment rate).  Quoting a study coming from the St. Louis Federal Reserve.  "...this resulted in a total number of unemployed persons of 52.81 million. Given the assumption of a constant labor force, this resulted in an unemployment rate of 32.1%."  From:

Stifel's Chief Economist Lindsey Piegza presents more "optimistic" view that unemployment could peak at 15% with a slow recovery.  Economy was already in downturn before the CoVid-19 shock:


On April 3rd, 2020, the US stock market (the S&P-500) was heading down after peaking in February 2020 at 3386.  The regression trend line from the February peak would have hit 1500 around May 10, 2020 at that time.  See graph below.

The S&P-500 at 1500 would represent a 56% drop from the high of 3386 reached on February 19, 2020.  Is that reasonable?  Yes - we had a 58% drop in 2007-2009.  We look at several ways of estimating what "fair value" of the S&P-500 would be and find that the S&P-500 "bottoming" around 1500 is not unreasonable.

The timing is likely to be considerably longer than the few months the regression curve indicates.  Significant downturns have always had intermediate rallies which can last for months.  The "dot-com bubble" in 2000 took 3 years to go from peak to trough.  The "housing bubble" of 2007-2009 took 1.5 years to do the same.  The "Crash of 1929" took nearly 4 years to reach bottom.  See chart below.

1.  Previous Boom-to-Bust Ratios

We had stock highs followed by crashes in 2000 ("dot-com" bubble) and 2007 ("housing bubble").

The S&P-500 peaked at 1552 in 2000, and 1576 in 2007.  Then it dropped.  We see how far it dropped in the chart below from "Yahoo Finance".

Each bar in the chart is a month.  Note the "rallies" interspersed along the downward trend.
Looking at the above chart, we see a 43% drop in the 3-year long 2000-2003 crash after the "dot-com" bubble.  A 43% drop now would mean the S&P-500 would bottom out at 1930 (or maybe "1929").

We saw a 58% drop in the 17-month crash of 2007-2009 after the "housing bubble". A similar sized drop now would give us 1422 on the S&P-500.

Based on previous boom-bust periods, a drop of the S&P-500 to the range [1422 - 1930] is not unreasonable - so 1500 is distinctly possible.    The Dow equivalent range would be 13,000 to 18,000.

2.  Shiller CAPE Ratio:

Our second way to find a bottom is to look at "market value" and see what a fair value would be.  One estimate of market value is the Shiller CAPE Index.  Dr. Robert Shiller of Yale University won the 2013 Nobel Prize in Economics for his work in 'Asset Valuation'.

Dr. Robert Shiller in Stockholm 2013
The stock market is one asset his valuations are most famous for (housing is another).  The Shiller Cyclically Adjusted Price Earnings (CAPE) Ratio simply takes the price of an equity or index and divides it by the 10-year average annual earnings of the stock or index.

CAPE Ratio = Price/(10-Year Avg. Earnings)

The 10-year span of earnings smooths out the almost random year-to-year cyclical fluctuations.  Annual earnings may significantly decline in the next year but the 10-year average will not move that much so this is a reasonable measuring stick.  The next chart shows the CAPE Ratio going back to the 1870s.  Note that it indicates extraordinary overvaluation in 2018, higher than "Black Tuesday" in 1929:

Shiller PE at 23.48 on April 3, 2020
The Shiller CAPE ratio is currently at 23.5 but the median over the last 150 years is 15.8.  For the ratio to get to its' historic median it would need to drop about 33% from current levels.  Further, the CAPE ratio overshoots both ways.  In 2000 it overshot to the high side to hit 44, and in 1982 it overshot to the low at around 7 - see above chart.

With the S&P 500 currently at 2485, to achieve the median Shiller P/E value, the market would need to drop to [ (15.77/23.48) x 2485 ] = 1669 to reach the median value of 15.8.  Nothing prevents it from going below that median value (for years) as it did in the 1970's, 1940's, and early 1900's - see chart above.  If it went as low as 10 where it was from 1975 to 1985, the S&P-500 would bottom at 1058.

While higher than 1500, S&P-500 = 1669 is close enough that 1500 isn't unreasonable, especially when we consider the various times when it has gone below the median value and stayed there for extended periods.

3.  Buffett Ratio:

If you add up the value of all the shares in the stock market you get what is called the "Total Market Capitalization" (TMC).  Warren Buffett popularized a way of determining if the broader stock market is over- or under-valued using the TMC of all stocks divided by the GDP (Gross Domestic Product = all goods and services in the US economy).

Buffett Indicator = TMC/GDP

The chart below shows GDP in green, Total Market Cap in blue.  When the TMC is above the GDP the stock market is expensive by Buffet's criterion.
The next graph shows the TMC/GDP Ratio, which is what we are really interested in.  In the graph below, "Fair Value" is marked between the red 90% line and the blue 75% line.  Note that since the early 1970's we've had a "fairly valued" market only in passing.
The market has been mostly undervalued or overvalued according to Buffett's indicator.  Please note that by this criterion, the market was extraordinarily overvalued in January 2020 at 150%, even more overvalued than the 140% reached in the Dot-Com Bubble of 2000.  We saw similar overvaluation in the previous Shiller chart as well.  This is why we say the current market drop was an avalanche waiting to happen.

From the peak value of 3386, we would need to see S&P-500 fall to between [1693 to 2031] (15,000 to 20,000 Dow avg.) to get to the [0.75 - 0.90] TMC/GDP "fair value" range.  However, that assumes a constant GDP (the denominator).  If GDP shrinks, then the TMC (numerator) would need to decline as well to achieve these indicator levels.  This would cause the actual value of the S&P-500 to fall into a lower range than the above.

Note that the last two market crashes from the 2000 and 2007 high values broke through the lower 75% line - almost reaching 50% in 2009.  A drop to a 50% TMC/GDP Ratio would bring the S&P-500 to 1129! (Dow equivalent 10,000!)  This would be extreme but we saw a similar drop in 2009, with a very swift rebound into the "Fair Value" range.

Also worth noting is that the Buffett ratio stayed well below "Fair Value" from March, 1973 to September, 1995 - more than 22 years!  There is no guarantee of a swift rebound.

Again the numbers we are getting are diverse but indicate that the S&P-500 at 1500 is not unrealistic.

4.  Price to Sales Ratio (P/S)

This is a pretty easy-to-understand measure of stock market valuations.  Divide the price of the stock or index by the sales per share.  More on this method here:

As seen in the graph below, the price-to-sales ratio for the S&P-500 was extraordinarily high (2.32) at the peak in December, 2019.  The price-sales ratio was at the median value before the 2008 crash before sinking to a very low 0.80 in March 2009.  The median value is 1.48.
To get back to the median Price/Sales ratio of 1.48 the market would need to drop to 64% of it's maximum value of 3386.  At 64% of its peak value, this puts the S&P-500 at 2167If it overshoots down to 0.80 as it did after the housing bubble crash of 2008-2009 then we would see an S&P-500 at 1168!

Note that this overshoot down gets us extremely close to the Buffett indicator value of S&P-500 = 1129 we saw as a lower bound for the same 2008-2009 period.  Having two dissimilar indicators produce similar results for extreme conditions gives more confidence in the result.

This only looks at the "price" part of the ratio - the numerator.  It assumes the "sales" part - the divisor - stays constant.  It is far more likely that sales will decline as well, and the S&P value of 2167 value will be excessively optimistic.

In any event, S&P-500 at 1500 is distinctly possible.

5.  EV to EBITDA Ratio

This metric is a variation of the popular P/E (Price/Earnings) ratio.  Instead of price it uses Enterprise Value (EV).  Enterprise value is the market capitalization minus debt.  Instead of earnings it uses the Earnings, Before, Interest, Taxes, Depreciation, and Amortization (EBITDA - sometimes shortened to EBIT).  More at:

Reported earnings can be manipulated by companies to show greater or less earnings while EBITDA comes before any manipulation.  More on EBITDA here:

The next chart shows the EV/EBITDA ratio (in red) tracks very closely with the Price-Sales ratio (in blue) and by the end of 2019 was similarly out of whack.  Since EV/EBIT and Price/Sales are so similar we mention it as yet another indicator confirming our previous estimates of where a bottom to the current crash might be.
We will spare you (and ourselves) the pain of going through another set of calculations.  We just point out that here is yet another widely accepted indicator showing the S&P-500 was seriously overvalued in 2019 - a crash waiting to happen.

Yet again, we see that S&P-500 at 1500 (or the Dow around 14,000) would be perfectly in line with standard metrics and historical precedent.

Nothing is certain, especially with the CoVid-19 virus mutating, potential vaccines, and other unknowns affecting things.  It does seem that the market was unusually over-valued in 2018-2019 and was overdue for a "correction".  That "correction" seems to have a while to go both in time and distance.

"You needn't be so haughty.  I lost just as much in the stock market as you did!"
from 1930 "New Yorker"
For now, this is...