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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