Saturday, March 7, 2009

Why the stock market still has a long way to fall.

I've written a lot over the past two years on how the average earnings multiple for the market in a lengthy recession is just ten. That's the average. Which means it starts out higher but also trades for much lower for a time. This market has traded insanely high for the last two years, as I've mentioned in frustration over and over again.

The S&P 500 is finally now at an earnings multiple of 10.2, which means it is finally getting more into line with past recessions, but we've still got an awful lot of room left to fall. Even if investors decide to continue to pay 10 times trailing earnings in the market, earnings themselves will continue to collapse. Right now, the S&P 500 is reporting operating earnings of around $62 per share. It was about $90 per share at the peak of the market in late 2007. I expect operating earnings to continue to fall to $45 per share. The "As Reported" earnings number for the S&P 500 - which includes one time charges and write-offs - is already at $45.95 right now. Right now you're probably doing the math in your head and realizing that $45 x 10 = an S&P 500 of just 450. It was 1,600 not that long ago, but I think this is entirely reasonable.

In the last two lengthy recessions ('82 and '74) we saw the market paying just seven times trailing earnings, and this recession is worse than those two. This recession will be longer and see greater earnings declines. We'll also see greater de-leveraging because back then we didn't have financial firms levering themselves at ratios of 30:1 or even 100:1 on a regular basis.

To come up with a price floor, we can take earnings of $45 per share and assume an earnings multiple of seven. 45 x 7 = 315. If you want to be conservative, lets assume the S&P 500's $62 earnings only drop to $55, and the market continues to pay the same multiple it does right now of around 10.2. 55 x 10.2 = $561.

So with this simple math and these simple concepts we've produced a final range for the worst of the S&P 500 of between 315 and 561. Either one gives you a large drop from the 682 we're seeing today.

In my personal view, this is the proper way to predict the market, and tells you so much more, with so much more confidence, than any technical analysis ever could. I'm perfectly open to telling you I haven't a clue where the market will go next week, next month, or in the next quarter. Not one clue. But I am confident that the numbers produced above tell us where the bottom will be. Stocks could run up 50% in the next month for all I know. But eventually, they have to fall to meet the underlying businesses that are themselves falling. Stocks always catch up with the underlying businesses they represent.

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