Stocks have enjoyed a great run since the 2018 Christmas Eve Massacre. That one-day meltdown capped a three-month crash of stocks of over 11% from Oct. 1–Dec. 24, 2018. The market turned around on the next trading day, Dec. 26, in the Boxing Day rally and has been going strong ever since.

The turnaround came because of a pivot by the Federal Reserve. First, the Fed indicated that it would not raise rates for an indefinite period and would give the market advance notice of any future rate increases. This was done by using the world “patient” in a speech by Fed Chair Jay Powell. The market understood that when the word “patient” is removed, rate hikes are back on the table.

Then by early spring, the Fed went further and indicated it would actually cut rates (which it did on July 31). The Fed also put an early end to quantitative tightening, QT. This amounts to another form of Fed ease.

But markets are looking for further rate cuts in September like a kid demanding more candy. The market-Fed dynamic is clear as far as it goes. But what about market fundamentals and economic history?

Here the picture is much less rosy. According to this article, stocks have only been as overpriced as they are today on two prior occasions — 1929 and 2000. The result in 1929 was an 80% crash in major stock markets and the Great Depression. The result in 2000 was an 80% crash in the Nasdaq due to its dot-com listings.

Stock gains have been driven by earnings, but earnings were boosted by stock buybacks and accounting gimmicks that are running out of steam. The overvaluation metric is computed using the Shiller/CAPE P/E ratio looks at 10-year time series in order to smooth out short-term gimmicks. The CAPE or P/E ratio is 31 today compared with a still-high P/E of 22.5 using more conventional methods.

The stock market may not crash tomorrow, but it is clearly headed for a slowdown (at best) or a crash (at worst). This is a great time to increase cash and partly diversify out of stocks to bonds and hard assets.

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