The Next Dow Crash: The X Factor You Need to Understand

Many believe the Dow Jones Industrials have risen too far too fast. But here's why it's hard to predict the next crash.

May 25, 2014 at 7:05PM
Longview

The Dow Jones Industrials (DJINDICES:^DJI) didn't manage to set a new all-time record high last week, but the stock market has performed extremely well, both in the recent past and ever since the depths of the financial crisis in early 2009. Given how far the Dow has soared in just over five years, many expect a crash to come eventually, and some believe that it could come sooner rather than later. Yet there's a critical factor in determining the timing of the next stock market plunge that market participants are struggling with, because there are conflicting signs of whether share prices in the Dow Jones Industrials and the S&P 500 (SNPINDEX:^GSPC) have gotten too expensive. The single X factor that is creating the most uncertainty is whether the financial crisis was a one-off aberration or a part of a natural business cycle that investors should take into account.

Crash

The CAPE debate
At issue is one of the simplest yet often misunderstood measures of stock market valuation: the price-to-earnings ratio. Many investors look at how share prices compare to the earnings of the businesses that underlie those stocks to determine whether a given stock is valued too highly or too lowly. Earnings multiples that are too high are often the precursor to major Dow crashes, while low earnings multiples tend to precede big bull-market moves that produce unusually strong returns.

By itself, the P/E ratio gives only a one-time snapshot at market valuation, based on a very short timeframe. With corporate earnings having climbed substantially since the Great Recession, P/E ratios based on estimates of future earnings over the past 12 months are still at relatively normal levels. Those figures suggest that even after the massive run-up in the Dow Jones Industrials and the S&P 500 over the past five years, the stock market could have further to rise before getting truly expensive, let alone setting itself up for a big crash.

But by another measure, the Dow and the S&P 500 are already on the expensive side. The cyclically adjusted P/E ratio, or CAPE, goes back more than 12 months in looking at earnings, instead taking an average over the past 10 years to include entire business cycles. When you expand your time horizon to include the negative earnings during the financial crisis, then the average earnings fall dramatically, and that pushes the cyclically adjusted P/E ratio much higher than the forward P/E, with the current CAPE level on the S&P 500 being roughly 25. In the past, the CAPE has gone higher than that, but future returns even from current levels tend to be well below the long-term average.

Looking at alternatives
The other thing to keep in mind is that past crashes have tended to occur at times when interest rates were much higher, making safer investments like Treasuries look more attractive. In late 1987, Treasury bonds offered rates of more than 9%. That meant that any P/E ratio above 11 for the Dow Jones Industrials had to be based on the growth potential of stocks -- growth that was already taxed by high valuations. Now, though, with bonds paying 2.5%, stock valuations can be much higher before bonds look attractive by comparison.

At some point, the Dow Jones Industrials and the S&P 500 will start to decline, whether in a cataclysmic crash or in a longer bear market. Market participants need to decide whether they think the financial crisis was an aberration -- in which case they should look at forward earnings multiples -- or something they must consider -- in which case they should focus on the CAPE. Until they do, it'll be impossible to predict when the Dow might rise so high that a crash becomes unavoidable.

Top dividend stocks for the next decade
The smartest investors know that dividend stocks simply crush their non-dividend paying counterparts over the long term. That's beyond dispute. They also know that a well-constructed dividend portfolio creates wealth steadily, while still allowing you to sleep like a baby. Knowing how valuable such a portfolio might be, our top analysts put together a report on a group of high-yielding stocks that should be in any income investor's portfolio. To see our free report on these stocks, just click here now.

Dan Caplinger and The Motley Fool have no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

1 Key Step to Get Rich

Our mission at The Motley Fool is to help the world invest better. Whether that’s helping people overcome their fear of stocks all the way to offering clear and successful guidance on complicated-sounding options trades, we can help.

Feb 1, 2016 at 4:54PM

To be perfectly clear, this is not a get-rich action that my Foolish colleagues and I came up with. But we wouldn't argue with the approach.

A 2015 Business Insider article titled, "11 websites to bookmark if you want to get rich" rated The Motley Fool as the #1 place online to get smarter about investing.

"The Motley Fool aims to build a strong investment community, which it does by providing a variety of resources: the website, books, a newspaper column, a radio [show], and [newsletters]," wrote (the clearly insightful and talented) money reporter Kathleen Elkins. "This site has something for every type of investor, from basic lessons for beginners to investing commentary on mutual funds, stock sectors, and value for the more advanced."

Our mission at The Motley Fool is to help the world invest better, so it's nice to receive that kind of recognition. It lets us know we're doing our job.

Whether that's helping the entirely uninitiated overcome their fear of stocks all the way to offering clear and successful guidance on complicated-sounding options trades, we want to provide our readers with a boost to the next step on their journey to financial independence.

Articles and beyond

As Business Insider wrote, there are a number of resources available from the Fool for investors of all levels and styles.

In addition to the dozens of free articles we publish every day on our website, I want to highlight two must-see spots in your tour of fool.com.

For the beginning investor

Investing can seem like a Big Deal to those who have yet to buy their first stock. Many investment professionals try to infuse the conversation with jargon in order to deter individual investors from tackling it on their own (and to justify their often sky-high fees).

But the individual investor can beat the market. The real secret to investing is that it doesn't take tons of money, endless hours, or super-secret formulas that only experts possess.

That's why we created a best-selling guide that walks investors-to-be through everything they need to know to get started. And because we're so dedicated to our mission, we've made that available for free.

If you're just starting out (or want to help out someone who is), go to www.fool.com/beginners, drop in your email address, and you'll be able to instantly access the quick-read guide ... for free.

For the listener

Whether it's on the stationary exercise bike or during my daily commute, I spend a lot of time going nowhere. But I've found a way to make that time benefit me.

The Motley Fool offers five podcasts that I refer to as "binge-worthy financial information."

Motley Fool Money features a team of our analysts discussing the week's top business and investing stories, interviews, and an inside look at the stocks on our radar. It's also featured on several dozen radio stations across the country.

The hosts of Motley Fool Answers challenge the conventional wisdom on life's biggest financial issues to reveal what you really need to know to make smart money moves.

David Gardner, co-founder of The Motley Fool, is among the most respected and trusted sources on investing. And he's the host of Rule Breaker Investing, in which he shares his insights into today's most innovative and disruptive companies ... and how to profit from them.

Market Foolery is our daily look at stocks in the news, as well as the top business and investing stories.

And Industry Focus offers a deeper dive into a specific industry and the stories making headlines. Healthcare, technology, energy, consumer goods, and other industries take turns in the spotlight.

They're all informative, entertaining, and eminently listenable ... and I don't say that simply because the hosts all sit within a Nerf-gun shot of my desk. Rule Breaker Investing and Answers contain timeless advice, so you might want to go back to the beginning with those. The other three take their cues from the market, so you'll want to listen to the most recent first. All are available at www.fool.com/podcasts.

But wait, there's more

The book and the podcasts – both free ... both awesome – also come with an ongoing benefit. If you download the book, or if you enter your email address in the magical box at the podcasts page, you'll get ongoing market coverage sent straight to your inbox.

Investor Insights is valuable and enjoyable coverage of everything from macroeconomic events to investing strategies to our analyst's travels around the world to find the next big thing. Also free.

Get the book. Listen to a podcast. Sign up for Investor Insights. I'm not saying that any of those things will make you rich ... but Business Insider seems to think so.


Compare Brokers