Tuesday, March 03, 2009

How low will equity markets go

No one knows where the bottom of this bear market will be because, as I just pointed out, nobody knows how bad the economic contraction will be. 

But let me provide some food for thought. If you look at the S&P500, the historic average price/earnings ratio is about 15 (based on trailing net earnings). Currently, with the S&P trading around 700, the P/E ratio for the S&P is about 18 (having peaked during the 2003 Bush bubble at around 60). That suggests that just on the mere earnings merits, the market is still overvalued, though not by much.

But to guess where the bottom of the market is likely to be, one should keep two additional facts in mind.

First, markets almost always overshoot on the way down. In fact, if you look at the two historically bad bear markets during the twentieth century -- the 1933 bear market and the 1974 bear market -- the bottom only came when the P/E ratio for the S&P500 had fallen to 6. Replaying that history suggests that the S&P500 may drop to around 230.

Second, because we're in a horrible real-economy contraction, corporate earnings are going to drop precipitously. Let's conservatively estimate that collective corporate earnings are likely to contract by a third before we hit the bottom. If you combine that with the previous assumption, namely that the P/E ratio will bottom at 6, then it suggests that the S&P500 may bottom out closer to 150.

Run the same logic for the Dow Jones Industrial Average, and it suggests that the bottom may be around 1400 -- which would represent a 90% decline from the peak, the same as took place during the Great Depression.

Note that this is not the worst case scenario, but rather a "historically average" scenario. I went to talk in Switzerland last Fall where I heard John Casti predict that the Dow would be in three-digit territory before this is all said and done.

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