In my book, The Great Recession, there is a chapter on stock market cycles. I show that the movement in the value of stocks and shares is closely correlated with the movement in the profitability of capitalist production.
Indeed, there is a cyclical movement in stock market prices with an up phase (called the bull market) that lasts about 18 years and a down phase (called the bear market) which also lasts about 18 years.
This stock market cycle lags a similar movement in capitalist profitability by about two years. Thus when the profitability of US capitalist production reached a cyclical low in 1980, the stock market followed in reaching a bear market low in 1982. Similarly, when US profitability reached a high in 1997 and then started to fall, the stock market reached its peak in 2000, before crashing.
The lag can be explained by the fact that falling profitability does not immediately translate into falling profits or corporate earnings. Profit margins may narrow but the absolute level of profits can go on rising as production accelerates to compensate for lower returns on each unit of investment or production. That cannot go on indefinitely, of course. Eventually the mass of profit will stop rising and even start falling and then that will end the enthusiasm of investors, who will start selling stocks.
How can you tell if the stock market cycle is a bear or bull market and when it will turn? Obviously, it depends on knowing if the economy is in a up phase or down phase for profitability. But there are two good measures of stock market prices that can reveal the stage in the cycle. The first is called Tobin’s Q, named after the economist James Tobin. This measures the market price value of all the stocks quoted any stock market against the replacement book value of the real assets owned by the companies with quoted stocks.
The market price ought to be in line with the real value of assets that companies have. A bull market in stocks will drive the market value of stocks above the book value of company assets and a bear market will do the opposite. In the anarchic world of capitalism, the Q ratio can reach extremes and that is a guide to the moment of turning.
More on Tobin’s Q on another occasion. But the other measure is to look at the value of the stock market against the total earnings or profits achieved by the companies quoted in the market. This is called the price to earnings ratio (P/E). A bull market would be when price rises outstrip earnings growth and the P/E rises and vice versa for the bear market. Again, when the ratio reaches an extreme high or low, we can expect a turn in the stock market.
But what is the extreme point? The American economist Robert Shiller has developed a P/E measure of the stock market that measures the market value price of the US stock market divided by earnings after inflation and then smoothed or averaged out over ten years. The result provides a very clear guide to whether the stock market is in a bull or bear phase.
Shiller’s graphic clearly shows that the stock market has a cycle that closely matches the one of profitability that I have identified in my book. US profitability peaked in 1997 and fell back until 2001. Despite a rally in profitability from 2001 to 2005, the rate of profit remained below that of 1997. After 2005, profitability began to fall again, culminating in the Great Recession of 2008-9.
The US stock market value peaked in 2000 (Shiller shows with a P/E ratio of 43) and fell back to low of 21 in 2003, then rallied to a high of 27 in 2007 before slumping again to 13 in 2009. It has now rallied back to 21, just as profitability has also recovered somewhat in the last six months.
But the bear market phase can be expected to last for up to 18 years, which suggests that the stock market has another leg down to suffer. The P/E low of the past bear market of 1964-82 was under 7 before the stock market turned into a bull market that lasted until 2000 (with some small intervals of pause). This suggests that, even if the current stock market rally continues for a few more years, it will turn down again, eventually to reach a new bottom in about 2018.