Black Monday, October 1987

Cross-posted from

What caused the Black Monday crash of 1987? Analysts are often unable to identify a single trigger or cause.

Sniper points to a sharp run-up in short-term interest rates in the 3 months prior to the crash.

3 Month Treasury Bill Rates

Valuations were also at extreme readings, with PEmax (price-earnings based on the highest earnings to-date) near 20, close to its Black Friday high from the crash of 1929.

S&P 500 PEmax 1919 - 1989

Often overlooked is the fact that the S&P 500 was testing resistance at its previous highs between 700 and 750 from the 1960s and 70s (chart from macrotrends).

S&P 500 1960 - 1990

A combination of these three factors may have been sufficient to tip the market into a dramatic reversal.

Are we facing a similar threat today?

Short-term rates are rising but at 40 basis points over the last 4 months, compared to 170 bp in 1987, there is not much cause for concern.

13-week T-Bill rates

PEmax, however, is now at a precipitous 26.8, second only to the Dotcom bubble of 1999/2000 and way above its October 1987 reading.

S&P 500 PEmax 1980 - 2017

While the index is in blue sky territory, with no resistance in sight, there is an important psychological barrier ahead at 3000.

S&P 500

Conclusion: This does not look like a repetition of 1987. But investors who ignore the extreme valuation warning may be surprised at how fast the market can reverse (as in 1987) from such extremes.

PEMAX second highest peak in 100 years

I published a chart of PEMAX for the last 30 years on Saturday. PEMAX eliminates the distortion caused by cyclical earnings fluctuations, using the highest earnings to-date rather than current earnings. The idea being that cyclical declines in earnings reflect a fall in capacity utilization rather than a long-term drop in earnings potential.

Since then I have obtained long-term data dating back to 1900 for the S&P 500 and its predecessors, from

PEMAX for November 2017 is 24.34, suggesting that stocks are over-valued.


Outside of the Dotcom bubble, at 32.88, the current value is higher than at any other time in the past century. PEMAX at 24.34 is higher than the peak of 20.19 prior to the 1929 Black Tuesday crash, and higher than the 19.8 peak before Black Monday in 1987.

This does not mean that a crash is imminent but it does warn that investors are paying top-dollar for stocks. And at some point values are going to fall to the point that sanity is restored.

Robert Shiller’s CAPE ratio

Here is Robert Shiller’s CAPE ratio for comparison. CAPE attempts to eliminate distortion from cyclical earnings fluctuations by comparing current index values to the 10-year average of inflation-adjusted earnings.

Shiller CAPE 10 Ratio

While this works reasonably well most of the time, average earnings may be distorted by the severity of losses in the prior 10 years.

You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right.

~ Warren Buffett

Is the ASX over-priced?

On the weekend I discussed how earnings for the S&P 500 have grown by roughly 6.0% over the last three decades but the growth rate should rise as stock buybacks have averaged just over 3.0% a year since 2011. In an ideal world the growth rate would lift to close to 9.0% p.a. if buybacks continue at the present rate. Add a 2.0% dividend yield and we have an expected annual return close to 11.0%.

Forward Price Earnings Ratio for S&P 500

I conducted a similar exercise for the ASX using data supplied by

The first noticeable difference is that earnings for the ASX All Ordinaries Index grew at a slower pace. Earnings since 1980 grew at an average compound annual growth rate of 4.4%, while dividends grew at a much higher rate of 6.3%.

Forward Price Earnings Ratio for S&P 500

How is that possible?

Well the dividend payout ratio increased from the low forties to the high seventies. An average of just over 60%.

With a current payout ratio of 77% (Feb 2017), there is little room to increase the payout ratio any further. I expect dividend growth to match earnings growth (4.4% p.a.) for the foreseeable future.

Buybacks are not a major feature on the ASX, where investors favor dividends because of the franking credits. The dividend yield is higher, at just over 4.0%, for the same reason.

So the expected average return on the All Ordinaries Index should be no higher than 8.4% p.a. (the sum of dividend yield and expected growth) compared to an expected return of close to 11.0% for the S&P 500. That is, if buybacks are effective in lifting the earnings growth rate.

Obviously one has to factor in expected changes in the (AUDUSD) exchange rate, but that is a substantial difference for offshore investors. Local investors are also taking into account franking credits which benefit could amount to an additional 1.4% p.a.. But that still leaves a grossed-up return just shy of 10 percent (9.8% p.a.).

I would have expected a larger risk premium for a smaller exchange with strong commodity exposure.

S&P 500 Price-Earnings Ratio rises

With 84.4% of S&P 500 index constituents having reported first-quarter earnings, 302 (73.84%) beat their earnings estimates while 77 (18.83%) missed. Forward estimates for 2017 contracted by an average of 4.6% over the last 12 months but not sufficient to raise the forward Price-Earnings Ratio above 20. That is the threshold level above which we consider the market to be over-priced.

Forward Price Earnings Ratio for S&P 500

Comparing the forward estimates for 2017 to actual earnings for 1989, we see that the market is expected to deliver a compound average growth rate of 6.0% over almost three decades.

With a dividend yield of 2.16%, that delivers a total return to investors of just over 8 percent.

Price-Earnings ratios fluctuate over time, so any improvement in the ratio should be considered temporary.

Buybacks have averaged just over 3 percent since 2011. The motivation for buybacks is that they should accelerate earnings growth but there is little evidence as yet to support this. As Reported Earnings grew at an average rate of 3.2% between December 2011 and 2016, below the long-term average.

A spike in earnings is projected for 2017 and 2018. Hopefully this continues. Else there will be a strong case for restoring dividends and reducing stock buybacks.

Forward P/E turns back up

Dow Jones Industrials

Dow Jones Industrial Average continues to climb, heading for a target of 21000. Rising troughs on Twiggs Money Flow signal strong buying pressure.

Dow Jones Industrial Average

The S&P 500 follows a similar path.

S&P 500

With the CBOE Volatility Index (VIX) close to historic lows around 10 percent.


However, at least one investment manager, Bob Doll, is growing more cautious:

“…we think the easy gains for equities are in the rearview mirror and we are growing less positive toward the stock market. We do not believe the current bull market has ended, but the pace and magnitude of the gains we have seen over the past year are unlikely to persist.”

Forward P/E Ratio

Bob Doll’s view is reinforced by recent developments with the S&P 500 Forward Price-Earnings Ratio. I remarked at the beginning of February that the Forward P/E had dropped below 20, signaling a time to invest.

Actual earnings results, however, have come in below earlier estimates — shown by the difference between the first of the purple (latest estimate) and orange bars (04Feb2017) on the chart below.

S&P 500 Forward Price-Earnings Ratio

In the mean time the S&P 500 index has continued to climb, driving the Forward P/E up towards 20.

This is not yet cause for alarm. We are only one month away from the end of the quarter, when Forward P/E is again expected to dip as the next quarter’s earnings (Q1 2018) are taken into account.

S&P 500 Forward Price-Earnings Ratio

But there are two events that would be cause for concern:

  1. If the index continues to grow at a faster pace than earnings; and/or
  2. If forward earnings estimates continue to be revised downward, revealing over-optimistic expectations.

Either of the above could cause Forward P/E to rise above 20, reflecting over-priced stocks.

Be fearful when others are greedy and greedy only when others are fearful.

~ Warren Buffett

S&P 500 Price-Earnings suggest time to buy

The forward Price-Earnings (PE) Ratio for the S&P 500, depicted by the blue line on the chart below, recently dipped below 20. In 2014 to 2105, PEs above 20 warned that stocks were overpriced.

We can see from the green and orange bars on the chart that the primary reason for the dip in forward PE is more optimistic earnings forecasts for 2017.

S&P500 Earnings Per Share and Forward PE Ratio

We can also see, from an examination of the past history, that each time forward PE dipped below 20 it was an opportune time to buy.

History also shows that each time the forward PE crossed to above 20 it was an opportune time to stop buying. Not necessarily a sell signal but a warning to investors to tighten their stops.

Sector Performance

Quarterly sales figures are only available to June 2016 but there are two stand-out sectors that achieved quarterly year-on-year sales growth in excess of 10 percent: Consumer Discretionary and Health Care.

S&P500 Quarterly Sales Growth

Interestingly, apart from Energy where there has been a sharp drop in earnings, sectors with the highest forward PE (based on estimated operating earnings) are the defensive sectors: Consumer Staples and Utilities. While Consumer Discretionary and Health Care are more middle-of-the-pack at 16.7 and 15.4 respectively.

S&P500 Forward PE Ratio by Sector

Nasdaq breaks its Dotcom high

Tech-heavy Nasdaq 100 broke through its all-time high at 4900, first reached in the Dotcom bubble of 1999/2000. Follow-through above 5000 would signal another primary advance. Bearish divergence on 13-week Twiggs Money Flow warns of medium-term selling pressure, possibly profit-taking at the long-term high.

Nasdaq 100

The daily chart of the S&P 500 also shows bearish divergence, but on 21-day Twiggs Money Flow, indicating only short-term selling pressure; reversal below zero would warn of a correction. Target for the advance is 2300*.

S&P 500 Index

* Target medium-term: 2100 + ( 2200 – 2000 ) = 2300

The chart below plots Forward PE (price-earnings ratio) against S&P 500 quarterly earnings. Apologies for the spaghetti chart but each line is important:

  • green bars = quarterly earnings
  • orange bars = forecast earnings (Dec 2016 to Dec 2017)
  • purple line = S&P 500 index
  • blue line = forward PE Ratio (Price/Earnings for the next 4 quarters)

S&P 500 Forward PE and Earnings

The recent peak in Forward PE was due to falling earnings. Price retreated at a slower rate than earnings as the setback was not expected to last. Forward PE has since declined as earnings recovered at a faster rate than the index. But now PE seems to be bottoming as the index accelerates. Reversal of the Forward PE to above 20 would be cause for concern, indicating stocks are highly priced and growing even more expensive, as the index is advancing at a faster pace than earnings.

Remember that the last five bars are only forecasts and actual results may vary. The only time that the market has seen a sustained period with a forward PE greater than 20 was during the Dotcom bubble. Not an experience worth repeating.

Defensive PE at a dangerous high

Low interest rates and the accompanying search for yield have driven the forward Price-Earnings ratio for Defensives to a 20-year high. This is likely to reverse when (not if) rates eventually rise. Cyclicals and Growth, however, still look reasonable.

7 golden rules for SMSF investors

I found myself nodding in agreement when I read this list from Dr Shane Oliver, Head of Investment Strategy and Economics and Chief Economist at AMP Capital. I have added my comments in italics.

Investing during times of market stress and volatility can be difficult. For this reason it’s useful for SMSF investors to keep a key set of things – call them rules – in mind.

1. Be aware that there is always a cycle
The historical experience of investment markets – be they bonds, shares, property or infrastructure – constantly reminds us they go through cyclical phases of good times and bad. Some are short term, such as occasional corrections. Some are medium term, such as those that relate to the three to five year business cycle. Some are longer, such as the secular swings seen over 10 to 20 year periods in shares. But all eventually contain the seeds of their own reversal. The trouble with cycles is that they can throw investors out of a well thought out investment strategy that aims to take advantage of long term returns and can cause problems for investors when they are in or close to retirement. In saying this, cycles can also create opportunities.

Most important is to identify the long-term, secular trends that may last several decades and position your portfolio to take advantage of this. Examples of secular trends are the ageing population in developed countries; the rapidly expanding middle-class in India and China; and global warming. Sectors that may benefit from them are Health Care and Consumables.

2. Invest for the long term
The best way for most investors to avoid losing at investments is to invest for the long term. Get a long term plan that suits your level of wealth, age and tolerance of volatility and stick to it. This may involve a high exposure to shares and property when you are young or have plenty of funds to invest when you are in retirement and still have your day to day needs covered. Alternatively if you can’t afford to take a long term approach or can’t tolerate short term volatility then it is worth considering investing in funds that use strategies like dynamic asset allocation to target a particular goal – be that in relation to a return level or cash flow. Such approaches are also worth considering if you want to try and take advantage of the opportunities that volatility in investment markets through up.

Invest for the LONG term, otherwise invest in low-risk assets (cash and near cash) and not clever strategies.

3. Turn down the noise and focus on the right asset mix
The combination of too much information has turned investing into a daily soap opera – as we go from worrying about one thing after another. Once you have worked out a strategy that is right for you, it’s important to turn down the noise on the information flow surrounding investment markets. This also involves keeping your investment strategy relatively simple – lots of time can be wasted on fretting over individual shares or managed funds – which is just a distraction from making sure you have the right asset mix as it’s your asset allocation that will mainly drive the return you will get.


4. Buy low, sell high
One reality of investing is that the price you pay for an investment or asset matters a lot in terms of the return you will get. It stands to reason that the cheaper you buy an asset the higher its prospective return will be and vice versa, all other things being equal. If you do have to trade or move your investments around then remember to buy when markets are down and sell when they are up.

Very important but this requires loads of patience, waiting for the right time to invest in the market.

5. Beware the crowd and a herd mentality
The issue with crowds is that eventually everyone who wants to buy will do so and then the only way is down (and vice versa during periods of panic). As Warren Buffet once said the key is to “be fearful when others are greedy and greedy when others are fearful”.

This is simply a repeat of Buy Low Sell High.

6. Diversify
This is a no brainer. Don’t put all your eggs in one basket as the old saying goes. Unfortunately, plenty do. Through last decade many questioned the value of holding global shares in their investment portfolios as Australian shares were doing so well. Interestingly, for the last five or so years global shares have been far better performers and have proven their worth.It appears that common approaches in SMSF funds are to have one or two high-yielding and popular shares and a term deposit. This could potentially leave an investor very exposed to either a very low return oif something goes wrong in the high -yield share that they’re invested in. By the same token, don’t over diversify with multiple – say greater than 30 – shares and/or managed funds as this may just add complexity without any real benefit.

Diversify into asset classes, geographic areas and strategies that have low correlation but don’t diversify into asset classes that offer negative real returns (after tax and inflation) or high risk relative to low returns.

7. Focus on investments offering sustainable cash flow
This is very important. There’s been lots of investments over the decades that have been sold on false promises of high returns or low risk (for example, many technological stocks in the 1990s, resources stocks periodically and the sub-prime asset-back securities of last decade). If it looks dodgy, hard to understand or has to be based on obscure valuation measures to stack up, then it’s best to stay away. There is no such thing as a free lunch in investing – if an investment looks too good to be true in terms of the return and risk on offer, then it probably is. By contrast, assets that generate sustainable cash flows (profits, rents, interest payments) and don’t rely on excessive gearing or financial engineering are more likely to deliver.

Most important. Invest in businesses with strong brands, patents or other competitive advantages that give them the ability to generate stable earnings over the long-term. Invest in stocks that you are likely to never sell but leave to the kids in your will. Occasionally you may sell one that falters but this should not affect long-term performance if you are well diversified.

Final thoughts

Investing is not easy and given the psychological traps that we are all susceptible to – in particular the tendency to over-react to the current state of investment markets – a good approach is to simply seek the advice of a coach such as a financial adviser.

Short-termism is the biggest danger to your investment portfolio. Too often I see investors do the exact opposite of what they should: buy high, when everyone else is buying, and sell low when everyone is a seller. Your best approach is to regularly consult an investment specialist.

Source: SMSF Suite – 7 golden rules for SMSF investors to keep in mind

The Stock Market’s Missing Ingredient | Bloomberg View

Barry Ritholz discusses why military conflicts around the globe and civil strife in Ferguson, Missouri have little impact on market performance:

….None of this seems to matter to Mr. Market. He continues to power on, oblivious to issues that don’t affect corporate earnings. They have, by the way, been stellar, growing at a 9 percent annual rate. Meanwhile, interest rates are still low and inflation is subdued.

Rarely have conditions for market gains been so promising at a time when investor psychology has been so negative. Gallup reports that only 7 percent of those surveyed were aware of last year’s scorching [29.7%] gains in the Standard & Poor’s 500 Index.

via The Stock Market's Missing Ingredient – Bloomberg View.