Overvalued Equities Suggest 58.9% Decline

Overvaluations and Market Declines

Short's overvaluation value represents the "average of the four valuation indicators from a geometric mean regression," expressed as a percentage. As of the end of August 2015, Short's average overvaluation was 78%. The comparable value preceding the great depression (1929-1933) was 74%. The subsequent peak to trough decline was 86.1%.

I took the analysis a step further and compared the degree of overvaluation to the peak to trough decline for each period. The correlation between the two values was -0.77 on a scale of -1.0 to +1.0. I then ran a linear regression, using the degree of overvaluation as the explanatory variable to forecast the subsequent peak to trough decline. The r-squared of the regression was 0.594, which indicates that the regression explained almost 60% of the variation in the peak to trough declines.

It gets even more interesting when we use the regression to forecast the expected market decline based on the current overvaluation of 78%. The regression estimates a decline of 58.9% with a standard error of plus or minus 15.3%. That certainly got my attention.

The US recession risk has increased and equity market technical and internals are very weak. If we reach a tipping point and fall into another recession, we could be looking at a very significant decline.

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About Brian Johnson

I have been an investment professional for over 30 years. I worked as a fixed income portfolio manager, personally managing over $13 billion in assets for institutional clients. I was also the President of a financial consulting and software development firm, developing artificial intelligence based forecasting and risk management systems for institutional investment managers. I am now a full-time proprietary trader in options, futures, stocks, and ETFs using both algorithmic and discretionary trading strategies. In addition to my professional investment experience, I designed and taught courses in financial derivatives for both MBA and undergraduate business programs on a part-time basis for a number of years. I have also written four books on options and derivative strategies.
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3 Responses to Overvalued Equities Suggest 58.9% Decline

  1. Chuck Milich says:

    Your book “Option Strategy Risk / Return Ratios: A Revolutionary New Approach to Optimizing, Adjusting, and Trading Any Option Income Strategy” provides Excel code that would be useful if the models were updated on a real-time basis. Is there a product or service that provides access to these models updated in real-time?

    Thank you for your assistance.

    • Chuck,

      I am not aware of any service that currently provides real-time risk return ratios, but it should be possible to create a spreadsheet with links to your broker platform to obtain the real-time information (primarily Greeks) required to calculate the risk return ratios.

      Best regards,

      Brian Johnson

  2. Pingback: Declining Earnings in an Overvalued Market | Trader Edge

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