Some people blame the recent stock market drop on the trade war with China. Others see different reasons. President Trump says, "It's a correction that I think is caused by the Fed and interest rates." These theories sound good. But the inconvenient truth carries much more weight. You might not have heard it because it’s a lot less entertaining.

Here’s the real reason U.S. stocks fell:

They were expensive, compared to corporate earnings levels.

No, they weren’t just expensive. They were priced in the stratosphere.

Only two times in history were stocks priced this high compared to corporate earnings levels. The first time was in the late 1920s, before the 1929-1930market crash. The second time was in the late 1990s, before the so-called lost decade. A $10,000 investment in the S&P 500 on January 1, 2000 would have been worth $9,016, ten years later–with all dividends reinvested.

The Lost Decade For U.S. Stocks
January 2000-December 31, 2009

The Lost Decade For U.S. Stocks - January 2000-December 31, 2009

Source: portfoliovisualizer.com

Investors shouldn’t have been surprised to see stocks fall in 2018. After all, stocks had been trading on thin ice since 2014. Let me explain.

Benjamin Graham was a finance professor at Columbia University. He was also Warren Buffett’s most influential teacher. One of Graham’s stock market axioms stands the test of time. He said, “Short term, the stock market is a popularity contest. Long term, it’s a weighing machine.”

Let’s focus on the short-term first. Graham said people’s fear and greed move the stock market, short-term. In other words, we move stock prices: you, me, and institutional traders. In December 2018, stocks fell heavily because more people sold than bought. When people saw stocks fall, many more sold. This brought stocks lower.

That’s why it’s impossible to predict short-term market movements with any degree of consistency. They rely on two very separate things:

  1. Economic News (Projections of future interest rates, future corporate earnings, future tax rates, future employment rates, future consumer spending rates etc).
  2. Human Reactions (Projections of how individual investors will react to any or all of the above).

Forecasting the economy is tough. But forecasting human reactions to the economy is a heck of a lot tougher. For example, imagine a series of famous economists. They unanimously claim that unemployment will hit an all-time high in six month’s time. Nobody has that kind of working crystal ball. But roll with this for a moment.

You might wonder if their forecasts are going to come true. But there’s something else to consider. If the economists are right, would people sell their stocks? Many would say, "Yes." And if more people sold than bought, the stock market would fall.

But our reactions to such news is tough to predict. In his book, Markets Never Forget, money manager Ken Fisher listed 14 historical periods when unemployment rates were six months away from hitting all-time highs. As strange as this sounds, with only one exception (July 30, 1946), the stock market increased over the following 12 months. On average, stocks gained 31.2 percent. This doesn’t mean you should stay out of stocks until soup kitchens outnumber Starbucks coffee shops. It does mean, however, that humans reactions to economic news might be tougher to predict than the economy itself.

This brings us back to Graham. He said the stock market, long-term, is a weighing machine. Such weight comes from corporate earnings. However, when stock prices rise much faster than corporate earnings, trouble usually lies ahead.

Over the past ten years, stock prices have left corporate earnings in their dust. That happened in the late 1920s. It happened in the late 1990s. At some point, institutional traders say, “This is getting crazy. Nosebleed prices always come back to Earth. Let’s take some money off the table.” Stock market prices can’t perpetually rise faster than corporate earnings. At some point, Mother Reality plays her card.

For proof, we can look at Robert Shiller’s CAPE ratio (cyclically-adjusted price-to-earnings ratio). It measures inflation-adjusted corporate earnings over a ten-year period and compares them to stock market prices. It’s much stricter than a typical price-to-earnings (PE) ratio which measures a single year’s earnings. If that year’s corporate earnings are artificially high or low, a traditional PE ratio could make the market look unrealistically cheap or expensive. But averaging inflation-adjusted earnings over a ten-year period is far more accurate.

Note the spikes in the chart below. This chart doesn’t represent stock market growth. Instead, it measures stock market prices compared to the corporate earnings of those stocks. You can see the sky-high CAPE ratios in the late 1920s and the late 1990s. You can also see today’s nosebleed level.

Historical CAPE Ratios For U.S. Stocks To January 1, 2019

Historical CAPE Ratios For U.S. Stocks To January 1, 2019

Shiller found that when the U.S. stock index trades significantly lower than its average CAPE ratio, stocks usually perform well in the decade ahead. That’s because they are cheap, relative to business earnings.

But when stocks trade significantly higher than their average CAPE levels, they usually perform poorly in the ten years ahead. That’s because they’re expensive, relative to business earnings.

CAPE ratios shouldn’t be used as a market-timing tool. Market timing doesn’t work. But CAPE levels give investors realistic long-term expectations. Even today, after the big year-end drop, U.S. stocks are still expensive. The decade ahead rarely bodes well when stocks are priced this high. That’s why investors should temper their expectations.

Larry Swedroe and Kevin Grogan’s book, Reducing The Risk of Black Swans, references CAPE ratio data from AQR Capital Management’s Cliff Asness. They found that when CAPE ratios exceed 25 times earings, the stock market’s compound annual average return beats inflation by a paltry 0.5 percent over the following ten years. The U.S. stock market’s CAPE ratio hit 25 times earnings in 2014. At the beginning of 2019, it was 27.5.

Note the blue bars below. They represent the average ten-year stock market returns following specific CAPE levels. The red bars show the best ten-year return, following respective CAPE levels. And the green bars show the historical worst case scenarios for ten-year returns after different CAPE levels.

Ranges of Compound Annual Stock Market Gains After Inflation
Based On Different CAPE Levels

Ranges of Compound Annual Stock Market Gains After Inflation -- Based On Different CAPE Levels

A seen above, when the stock market’s CAPE ratio was between 21.1 and 25.1, stocks beat inflation over the following ten years by an average annual compound return of just 0.9 percent.

When CAPE ratios were between 15.7 and 17.3 (that’s near the long-term average), stocks beat inflation by an average annual compound return of 5.6 percent.

And when CAPE ratios were below 9.6, stocks beat inflation by an average annual compound return of 10.3 percent.

U.S. stocks fell hard in December 2018. Pundits are blaming everything from the trade war with China to the Federal Reserve’s interest rate decisions. But here’s the inconvenient truth. Long-term, the stock market is (and always will be) a corporate weighing machine. When stocks are wildly expensive, they’re destined to cool off.

Unfortunately, despite their recent drop, U.S. stocks are still expensive. That doesn’t mean U.S. stocks won’t perform well in 2019 and 2020. But the decade ahead looks bleak.

Instead of trying to time the market, maintain a diversified, low-cost portolio of index funds. It should include U.S. stocks. It should also include developed international stocks and emerging market stocks (both are currently cheap, based on CAPE levels). Investors should also include bonds, based on their tolerance for risk. Once a year, rebalance the portfolio.

Ignore stock market news. And remember Benjamin Graham. He was right. Short-term, the stock market is a popularity contest. Long-term, however, it’s a weighing machine that almost never denies the truth–even when it hurts.

Andrew Hallam is a Digital Nomad. He’s the author of the bestseller, Millionaire Teacher and Millionaire Expat: How To Build Wealth Living Overseas