Could Stocks Drop ANOTHER 40%? History Says Yes…

Dear Rich Lifer,

Is the stock market due for more market downside?

There is absolutely no way to know for sure.

But in my opinion… Yes. Maybe another 30% or 40% even.

That is based on current valuations compared to historical ones.

Before I show you the actual numbers, let’s get the caveats out of the way…

The Caveats 

It’s one thing to buy a stock with the intention of selling it for a quick profit.

That’s trading and it can make a lot of sense, especially in the kind of volatile environment we have right now.

In fact, I recently told you how I had personally flipped two oil stocks for 30%+ gains in a matter of days during the big sell-off and subsequent rebound.

It’s also true that some stocks seemingly trade completely out of whack with their underlying fundamentals for months or years on end.

Even so, that disconnect can’t last forever.

Ultimately, stocks represent real businesses. Investors put their money into those businesses with the expectation of getting returns based on increasing profits over time – through rising stock prices based on the increasing earnings streams and/or direct receipt of the profits through dividend payments. 

Sticking with the relationship between a stock’s price and the underlying company’s earnings brings us to the idea of a price-to-earnings (P/E) multiple.

Calculating Price-to-Earnings 

You simply take the stock price, divide it by a company’s annual per-share earnings, and end up with a number.

For example, if stock XYZ costs $10 a share, and the company earned $1 in profits over the last year the stock is trading at a P/E of 10. ($10 divided by $1)

In this case, the multiple is a trailing twelve-month (TTM) P/E because it’s based on historical earnings.    

If the same company is expected to make $1.25 over the year ahead, its “forward multiple” is 8 (10 divided by 1.25).

Since most investors are looking forward, they typically care a lot more about forward P/Es and the potential for additional earnings growth over the next several years.

Still, it’s helpful to keep past and future in mind because they provide a more balanced view … and it’s even better if you look at several years of past earnings since results can vary for all kinds of reasons related to the company itself, the industry it operates in, as well as the economy at large.

Still with me?

Okay.

Now we’re ready to look at the broad S&P 500 index to get a sense of how the stock market is currently being valued.

S&P 500 Valuation 

Based on a March 31st closing price the S&P 500 was trading at 18.53 times reported 2019 earnings.

How does that compare with historical numbers?

If we just look at the last five years, pretty good.

Based on quarterly closing prices and TTM reported earnings, the S&P 500 traded at an average P/E of 22.64.

However, the last five years were largely full of wild optimism.

Including a full decade of data, the average P/E drops to 19.79. Using data all the way back to 1936, the average has been 17.26.

So we’re hardly in “bargain” territory … especially considering the fact that we’re using current beaten-down prices divided by last year’s very solid earnings.

The bigger question, then, is what will earnings be in 2020 … 2021 … and beyond.

Based on the same March 31st closing price, the S&P 500 is currently trading at 18.11 times Wall Street’s consensus estimate for 2020 earnings and 15.88 times 2021 estimated earnings.

Does it seem like a good deal to buy stocks at 18 times next year’s estimated earnings?

Not to me. 

After all, what are the odds those estimates still need to come down further?

We haven’t even begun to see the damage being done to businesses given the widespread shutdowns.

We also have no idea exactly how long the shutdowns will last …

And we can’t possibly know how quickly activity – especially discretionary spending from consumers – will resume even once official shutdowns are lifted.

That’s an awful lot of uncertainty, which hardly argues for paying high multiples… or even average ones.

In fact, it would be completely reasonable to expect stocks to drop another 30% or 40% from current levels just based on valuations during past crises (many of which weren’t nearly as economically damaging as what’s happening right now).

The CAPE Ratio

Yale Professor Robert Shiller has come up with his own version of the P/E ratio – which takes the market’s price and divides it by a 10-year earnings average. The idea is smoothing out the effect of wide variations in earnings over the typical business cycle.

Here’s chart of this so-called CAPE ratio courtesy of multpl.com

As you can see, the big market drop has brought the CAPE down to 24.61.

But that’s still quite elevated compared to the historical mean of 16.70 and the historical median of 15.77.

In fact, we’ve seen valuations drop under 10 during many of the worst events in history.

Taking the 2009 financial crisis as a more recent example, gives us a ratio around 15.

That would imply a further drop of roughly 40% in the S&P 500 from current levels.

Or, to look at it another way, the current CAPE is at the same level that has previously represented TOPS in past bull markets!

Only during the bubbles of 1929, 1999, and 2019 have we seen it go much higher than 25!

Food for thought …

To a richer life,

Nilus Mattive

Nilus Mattive

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Nilus Mattive

Nilus is the editor for the daily e-letter The Rich Life Roadmap and a Paradigm Press analyst.

Nilus began his professional career at Jono Steinberg’s Individual Investor Group, where he published his original research through a regular investment column. Later, he worked for a private equity business and spent five years editing Standard and Poor’s...

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