Shiller P/E and Margin Debt Signal Rising Stock Market Crash Risk

The Shiller Price-to-Earnings ratio and outstanding margin debt currently sit at historical extremes, two indicators that have historically preceded major stock market downturns. As of the closing bell on Oct. 7, the S&P 500's Shiller P/E ratio stood at 41.80, while margin debt reached a record 4.5% of GDP. These metrics suggest that the odds of a significant market decline under President Donald Trump are increasing, according to analysis from The Motley Fool.

Stock valuations have expanded significantly during President Trump's second term. The Dow Jones Industrial Average, S&P 500, and Nasdaq Composite have gained 18%, 30%, and 40%, respectively, since the start of his current term. This rally has been driven by the artificial intelligence infrastructure build-out, better-than-expected corporate earnings, and record share repurchases. The latter factor is linked to the Tax Cuts and Jobs Act from Trump's first term, which permanently lowered the peak marginal corporate income tax rate to 21%. Despite these gains, valuation tools indicate that current prices may be unsustainable.

The Shiller P/E ratio, also known as the CAPE Ratio, has an average of 17.42 over a backtested period of nearly 156 years ending in January 1871. The current reading of 41.80 is the second-highest in history. Over the last 156 years, the CAPE Ratio has exceeded 30 for at least two consecutive months only six times. The five previous instances all preceded significant market disasters. Premium valuations were observed before the Great Depression, which erased 89% of the Dow's value, and the dot-com bubble, which slashed the S&P 500 and Nasdaq Composite by 49% and 78%, respectively. While the ratio cannot pinpoint when a downturn will occur, it has successfully foreshadowed five major declines over the last century.

Outstanding margin debt provides a second signal of heightened risk. Margin debt is money an investor borrows from a broker with interest to purchase securities, acting as a form of leverage. FINRA reports this data monthly. While margin debt is expected to rise steadily with the overall stock market, parabolic surges in risk-taking have historically preceded market breaks. In August, US margin debt surged by $37 billion to reach $1.45 trillion, its second-highest level on record.

Year-to-date, margin debt has risen by $228 billion, or 19%. Since the end of 2022, investor borrowing has increased by $847 billion, or 140%. This growth has outpaced the S&P 500's gain of 98% over the same period. Consequently, margin debt as a percentage of GDP has almost doubled to a record 4.5%. By comparison, the highs during the 2021 and 2000 dot-com bubble were 3.6% and 2.8%, respectively.

Over the last 30 years, there have been four instances where outstanding margin debt surged by at least 65% in a relatively short time frame. The three previous events immediately preceded the bursting of the dot-com bubble, the financial crisis, and the 2022 bear market. Although neither the Shiller P/E ratio nor margin debt can guarantee a crash or specify its timing, their current levels correlate with historical periods that resulted in short-lived crash events.