What we can learn from past stock market crashes

Making Sen$e

Paul Solman: Stock market got you spooked? Afraid of a Wall Street Armageddon? Well, putting today's market in historical perspective isn't exactly reassuring.

But how about the explanation that stock prices were and still are historically out of whack? Stock prices of U.S. companies have recently reach their second highest level since 1888, according to Nobel laureate Robert Shiller, CAPE, or C-A-P-E, an acronym for cyclically adjusted price/earnings ratio.

Since a share of stock is, in theory, a share of a company's profits, a high P.E., or price/earnings ratio, means a high stock price relative to profits. Using the S&P 500 index, an average of 500 major companies, Shiller's CAPE has had three dramatic peaks, the Roaring '20s, the dot.com boom, and last week.

And though the index has dropped by about 10 percent, it's still above the ratio in October of 1929. So on a day like today, you may be wondering, how low could the market go?

Well, the first peak on Shiller's chart came in 1929, promptly followed by the crash of '29. And the S&P index bottomed out in March of 1933, having dropped by more than 80 percent. A similar drop from last week's peak of 2867 would drive the S&P below 600, the Dow below 5000.

And what's been the average price/earnings ratio over the entire 129 years? Somewhere around half of what the market closed at today. But before you panic, the highest Shiller peak ever was about 40 percent above the current ratio. That was during the first Internet boom, which lasted quite awhile.

So exuberance, whether irrational or not, could still have quite a ways to go. A repeat performance of the dot-com boom would imply an S&P index approaching 4000, a Dow nearing 35000.

Now, a warning out predictions. As I once heard the famous economics professor John Kenneth Galbraith say, there are two kinds of economists, those who don't know the future, and those who don't know they don't know.

And as another famous economist, Paul Samuelson, once said, the stock market has correctly forecast nine of the last five recessions.

Look, optimists have a seemingly strong case, with data to back them up. The U.S. and global economies appear to be doing just fine, with a U.S. unemployment rate of barely 4 percent, wages finally rising, business so good that companies may be borrowing to invest again at last.

And the S&P, even after this week's cascade, is still up more than 12 percent over the past 12 months, the Dow still up about 19 percent. But the pessimists point out that people were just as upbeat in 1929, when unemployment was, as best we can tell, below 3 percent and the 1920s were still roaring. And then look what happened.

You find this kind of unsatisfying, like President Harry Truman's famous lament that all my economists say, on one hand, then, but on the other? Well, what else is there but Truman's answer? Give me a one-armed economist.

For the PBS NewsHour, this is economics correspondent Paul Solman.

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