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The real reason why stocks are tanking

August 4, 2011: 3:20 PM ET

Stocks are expensive. Add to that a flurry of negative indicators -- even if they're not new -- and you've got a recipe for a correction.

FORTUNE -- Wall Street's analysts and money managers are conjuring all kinds of reasons why stocks are tanking. We keep hearing it's because the debt ceiling deal didn't contain the spending cuts investors hoped for, or the opposite, that the reductions in government spending will trip the U.S. back into recession. Or it could be the fear of sovereign defaults in southern Europe, or the weak consumer spending numbers here at home.

The probable reason is none of the above. Stocks are most likely falling because of two factors you won't hear from stock jockeys. First, they're moderately overpriced even for a calm, healthy economy. And second, with stocks on the expensive side, there's no cushion for bad news. None of the danger signs the pundits are citing are new, but the drumbeat of turbulence, from every corner of the world, is rising to a level that's suddenly making investors extremely nervous.

Hence, the combination of slightly inflated prices and an increasingly scary world makes stocks extremely vulnerable to a sharp decline. And that's what's playing out, day after day.

The best evidence prices are on the high side comes from the adjusted price-to-earnings multiple developed by Yale economist Robert Shiller. The Shiller number––or CAPE for cyclically adjusted-price earnings ratio -- smoothes out the peaks and valleys in earnings to measure whether stocks are really pricey or cheap, and don't simply seem so because earnings are either inflated or depressed. In July, before stocks started dropping, the CAPE stood at around 23. That's a bit higher than the 45-year average of 19.4, and well above the 130-year norm of 16.4.

In most markets, a Shiller PE of 23 wouldn't be particularly troublesome. But when times are rocky, investors eventually want a wide "risk premium" to compensate for all that uncertainty. High prices relative to earnings, even moderately high prices, mean that the comfort zone is narrow. Suddenly, investors may be reckoning they want far more margin for today's alarming level of risk.

There's only one way to get it: Lower prices that provide fatter earnings yields. Think what happens to the yield on junk bonds when times are tough.

Listen to Cliff Asness, the University of Chicago PhD economist who runs AQR Capital, a multi-billion dollar hedge fund: "It's fair to think that the market is on the high priced side, in a time when risk is certainly on the high side -- a bad and perhaps underappreciated combination." Asness adds that at these levels, prices, high but not themselves exceptionally scary by historical standards, provide absolutely no solace as the bad news comes in.

Solace is what investors want, and in stocks, solace only comes with the pain of lower prices.

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About This Author
Shawn Tully
Shawn Tully
Senior EDITOR-AT-LARGE, Fortune

Shawn Tully has been writing feature stories for Fortune since 1980. He's covered stories as varied as the Vatican's finances, the exile of fugitive commodities trader Marc Rich, and the disastrous merger between Guidant and Boston Scientific. He specializes in banking, federal budget and spending issues, and health care. Tully holds a B.A. in English from Princeton University, an M.B.A. from the University of Chicago, and a master's in Applied Economics from the Universite Catholique de Louvain in Belgium.

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