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The Stock Market Bubble That is About to Pop

Some investors believe that stock markets move in cycles.

A popular theory is the 10-year market cycle, where investors postulate that the stock market will crash every 10 years.

As the story goes, the cycle started on 19 October 1987, the infamous day remembered as “Black Monday”. On that fateful day, the US-based Dow Jones Industrial Index plunged over 22%. The record sell-off wiped out billions of dollars in a single day, shocking investors around the world.  Back home, Singapore’s Straits Times Index (SGX: STI) plunged over 12% in a single session, recording its deepest one-day crash in history.

It’s just another manic Monday

The market cycle theory picked up again in 1997, when the Asian financial crisis struck.

The regional crisis began when the Thai government floated the Thai Baht, and experienced an immediate 15% decline in value. 

Panic ensued. 

Within three months, the Indonesian rupiah, Malaysian ringgit and The Philippine Peso weakened considerably. As confidence started to erode across the region, credit tightened, and economic activity slowed down.

As the crisis deepened, stock markets were not spared. Between 1997 and 1998, the Straits Times Index fell by over 63% from peak to trough.  

That’s not the end of it. The market cycle theory hit home when – lo and behold – a decade later, economies worldwide were blown away by the 2007 global financial crisis.

Now, I won’t bore you with the gory details of the worldwide crisis, and will go straight to the meat of the argument. The Straits Times Index nosedived by over 62% between October 2007 and March 2009. 

As the theory goes, the global financial crisis makes it three major market declines, seemingly occurring every 10 years.

How intriguing.

The heartbreaking stories from 1987, 1997 and 2007 sets the stage for the present day; 2017 – the dreaded 10 years after 2007.

The market cycle theory goes bust

Yet, the idea behind the 10 year market cycle does not hold up upon closer scrutiny.

For example, how should we make of the dot-com bubble crash in the year 2000? In this case, the Straits Times Index got cut by more than half between 2000 and 2003. Should we sweep this 50%-plus decline under the rug simply because the data does not fit the market cycle theory?

There is another inconsistency to the theory when we look at the Asian financial crisis. In this instance, the Straits Times Index had already started declining from its high in 1996 when 1997 came along. In other words, the stock market decline started nine years after 1987, and not 10 years. Again, the market cycle theory does not hold up.

To cap it off, there is the small matter of valuation. 

According to Teh Hooi Ling’s study in 2013, the Straits Times Index was trading at price-to-earnings ratios of above 30 in 1987, 2000, and 2007. At the moment, the SPDR STI ETF (SGX: ^ES3), an exchange traded fund that mimics the fundamentals of the Straits Times Index, sports a PE ratio below 12.

The current valuation levels, measured by the PE ratio, is a far cry compared to the lofty levels of past market peaks.   

To be sure, markets do fall from time to time. But from where I stand, there is little evidence to suggest that stock markets will crash just because investors get dizzy from the planet spinning around the sun 10 times (that’s my overly geeky way of saying 10 years).

A Foolish Takeaway

When the market decides to head south shouldn’t be on the top of investors’ minds. 

History tells us that market declines will happen from time to time. Between 1993 and 2016, a period of 24 years, the Straits Times Index fell by more than 20% in a year (from peak-to-trough) on 10 occasions. In short, the data suggests that there is there is a fair chance of a fall of 20% (or more) in any given year.

The important thing is for us not to panic. Whether it is a 20% decline or a 60% decline, there will always be good companies in the stock market. My colleagues and I at Motley Fool's Stock Advisor Singapore spend our days looking for companies to ride out the uncertainties of the stock market. To learn more about what we do, click here.

The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Chin Hui Leong doesn’t own shares in any companies mentioned.