The real economy in many ways has recovered since the Lehman crash of September, 2008. So does this mean today’s stock prices with SP500 at 1256 are justified and that the bear case is wrong?
Using the principles of independent investment advice, the best way to judge the market is with the Schiller 10 year average P.E. ratio, which is at 22.7, versus a norm of about 15; also after a bad credit crunch it should have declined to 12, which is a 47% drop to SP at 664. Further the dividend of 2% should be at the historical average of 4.3%, which implies SP must drop 47% to 664.
The world economy has three main pillars: U.S., China, Europe. In the U.S. the housing crash with a huge oversupply of contingent inventory and delinquent debt still has not been resolved, thus house prices will go down. In Europe even Germany is threatened by the potential for failure in the southern area of the Euro zone. In China there is the risk of a bubble that will end as all bubbles do, in a crash. The best that could happen in China is a growth slowdown instead of a crash which would result in the world economy getting less stimulus during a time when the rest of the world’s economy is very weak.
The only reason for stocks to be so high is because of fear that they are the only haven from inflation (assuming investors don’t like commodities, gold, etc.). But if inflation returns it is not a straight pass-through for stocks; on a “real” basis stocks decline during times of inflation. Also, if inflation hits then interest rates will rise which will absolutely hurt the stock market. During times when interest rates are low the bulls say that low rates act as a lever to make stocks go up, but when rates go up the bulls are evasive about that issue. So if we remove the investor’s belief that stocks are a hedge against inflation and then a new series of U.S. and Euro area debt crahses occur and China’s economy cools down then there will nothing to support an overpriced stock market.