S&P 500: Plausible Downside Target of 500

We believe that the S&P 500 declining to the level of 500 is plausible before the current unpleasantness is over. That would put the index at the same approximate price as March 1995, before the internet bubble got well underway.

In a recent article, we made the case on the basis of earnings and normalized price-earnings ratios that the index could decline to between 600 and 400. The normalized P/E ratios used were taken from a long-term study we did of the S&P from 1936.

Ranges:

Most commentators refer to near-term upside targets in the vicinity of 950 to 1000 for the S&P 500, and to a clear bottom at about 750. That may well prove to be the case, but intellectual room should be made for a more severe correction before “the” bottom, instead of “a” bottom is reached at lower levels.

Dividend Perspective:

Before 1958, dividend yields were higher than bond yields, as investors recognized the inherently greater risk of stocks versus bonds. Perhaps recent stock problems will move investors back toward the pre-1958 perspective. That would put strong negative pressure on stocks.

Before Q4 2008, Obama campaigned on the theme of rolling back investment tax benefits passed during the Bush administration. Favorable taxation of dividends is prominent in those benefits. If the President and Congress follow-through on that and raise dividend taxes, that would put negative pressure on stock prices.

Banks, which recently accounted for 12+% of S&P 500 market-cap, generate more than 25% of total dividends for the index (proxy SPY). In addition to a general slowing of dividend increases across industries, the large banks that make up the bulk of the S&P financial sector (proxy XLF, and closely tracked by KBE) are dramatically reducing dividends. If the combination of business needs and TARP rules force virtually all large banks to reduce dividends to $0.01 per quarter, the S&P index would have to decline into the 600’s to restore the current 3+% index dividend yield.

Graphical Chart View:

This chart shows the historically above average P/E and the historically below average dividend yield compared to periods back to 1926.

click image to enlarge

It is difficult for us to believe that above average P/E ratios can be maintained in a below average earnings environment. Surely, if earnings hit a soft spot, index prices might fall less, with consequent elevation of the P/E ratio, but we are in much worse than a soft spot, both in degree and duration. We expect that the P/E should at least be in the long-term mid-range before the decline is over.

Similarly, dividend yields are lower than historical levels. Admittedly, Treasury rates are very low, but that does not seem to be a long-term sustainable level. When Treasury rates rise, dividend yields should rise too, putting downward pressure on stocks.

Long-Term Growth Rate Perspective:

Using a semi-log (constant % change for Y-axis) chart of the index since 1950, drawing a line across tops and bottoms before the internet bubble, you see a price range with a top near where we are today, but with a bottom well below. That approach suggests a range of 800 to 400 for the index.

click image to enlarge

Using an arithmetic chart (unit price change for Y-axis) from 1927, superimposing different growth rate curves, a general range of 1200+ to 400- presents itself, if you assume an approximate 4% to 5.5% price return (before additional return from dividends). The current near 800 level for the index corresponds roughly with a 5% price (excluding dividends) return over the past 81 years.

click image to enlarge

Back to the Plausible 500 Target:

We used a semi-log chart from 1926 through today and out to the end of 2010 (based on projections by Standard & Poor’s) in the following chart. Drawing lines across the tops and bottoms in the pre-internet bubble period, we see a top of range about where we are today, and a bottom of range that is at the level of about March 1995 (or about 500).

click image to enlarge

Summary:

The several approaches we have taken here, all produce a broad range of plausible downside price levels well below the 750 that has recently been heralded as “the” bottom by many commentators.

We recommend keeping powder dry until there is a clear pattern of upward price movement, and not just the index touching 800 or 750 as presumed bottoms. Consider the possibility of 600, 500 or even 400 if the world economy becomes as bad as the policy actions by governments suggest.

Whatever you decide to do, use persistent trailing stop losses on your positions, just in case the bottom falls out. It can happen. It has happened before, and it may happen again.

Comments

[CautiousInv...:]

Thanks for the well written and timely article.

I have long thought that, given the circumstances, current valuations are too high.

The S&P500 is trading at around 19X trailing earnings which is above the recent historical average of 16.

The only thing propping up the P/E ratio is low interest rates and low expectations for inflation. I think reduced expectations for earnings could erode the multiplier leading the market significantly lower.

Jan 21 07:16 AM

[ikkyu:]

Very nice piece of work. Exceptionally well thought out.
Thanks from Osaka,
john

Jan 21 07:54 AM

[Walter1234:]

A reversion to the mean of historical P/E ratios doesn't mean just bouncing off the mean. In previous serious recessions we have had P/E of 8 and less. To create a meaningful mean number the P/E ratio must pierce the mean to the negative in a fashion reasonably equal to the preceding upside, as has happened in serious recessions. So the question becomes: do you think we are in a serious recession...

Greetings from Peaks Island

Jan 21 09:01 AM

[basehitz:]

Thank you. It is greatly appreciated when thoughtful presentation is made of realistic assessments. . . as opposed to the sales propaganda that dominates financial journalism in the popular media.

Jan 21 09:35 AM

[QVM Group:]

Siggy:

Yes, I agree that overshooting boundaries is characteristic of tops and bottoms. P/E of 8 is certainly possible.

"Serious recession" is probably a fair statement, with global growth slowing, including negative GDP changes in major economies and reductions in growth and related financial stress in emerging economies.

We had an asset bubble and a credit bubble. We now have massive asset deflation and credit contraction. That has spilled over to lower consumption and lower production. The recession is the consequence of the asset and credit correction.

Depending on whose earnings projections you use (S&P at $42+ or GS at $53), an 8X P/E would put the S&P 500 in the 350 - 425 range --- down roughly 50% from where we are today.

For those of us who hold cash and patiently wait for the price action to tell us that the markets are going up, instead of buying now in reliance on hope or encouragement from spokespersons for asset gathering organizations, there is probably an historic profits opportunity ahead. There may even be a great long-term profits potential from here, but we’d rather wait until the markets clearly show they are done shaking out, and until the stream of new government policies seems to end, and the fundamental news stops getting worse.

How nice to hear a voice from Peaks Island. See you again soon.

Richard

Jan 21 09:46 AM

[kelm:]

This market has been riddled with savvy funds, Saudi Princes and Sages moving in after each leg down convinced they are getting great long term value. They are all well underwater. This market keeps surprising which will make choosing the entry point more difficult.

A well written piece. The numbers are in-line with other thoughtful analysis I've seen.

Jan 21 10:14 AM

[OldLimey:]

Great to read an article which expresses a clear view and sets out well-developed arguments in favour. Thanks for sharing the analysis.

Jan 21 01:28 PM

[mr freddo:]

This is a well organized, and thought provoking article. Given that we are in the most serious financial crisis since the Great Depression, and that it is far from over, a selloff toward a more reasonable p/e is a rational conclusion. We would like the bottom to be in but, with more bad news coming, and recovery a long time off, a bottom of 500 sounds pretty reasonable.

I'll keep some powder dry..

Feb 04 12:25 AM