Too Late to Short SPY? An Historical Perspective 17 comments
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So, the S&P 500 (SPY) is down over 40% from a year ago. All the talking heads on CNBC have their stories on what to do now. Scary times for sure, but what is the perspective that historical data suggest? Is it time to jump back in or do we have much further to fall? Should we go long on SPY, or short it?
The housing bubble has burst and we all buy into the idea that there’s another 10-25% to fall. Prof. Robert Shiller of Yale University has published historical data going back to 1890 (below) that shows a small variation in inflation adjusted home prices over 100+ years prior to 1995. Variations in fundamentals like interest rates, population and building costs have no correlation to the tremendous ramp up in housing prices after 1995. Common thinking held that real estate always went up has been broken. The real estate tipping point is behind us.
click to enlarge images
What about stocks? Panic is all around us. Must be close to a bottom, right? The stock bubble has burst (again). So what are the fundamentals? Shiller’s data on S&P500 P/E ratios dating back, again, over 100 years is shown below. Note that to take the “noise” out of the data, Shiller uses earnings over the previous 10 year period.
The market closed Wednesday, October 8, 2008, at a PE ratio of 14.6 for the S&P500, a tremendous drop from nearly 45 in 2000 and 25 earlier this year. This may feel like we’re close to a bottom, but the historical average going back to 1880 is 16.3. We reached PE lows close to 5 in 1921, 1932, and the early 1980s. I wasn’t around for the first two of these, but my dad was. He says the news today sounds almost as bad as it was in 1921 and 1932. I recall the early ‘80s and this feels worse to me. And earnings are likely to go down substantially from here.
Further, financial stocks over the last 10-15 years have contributed 30% of the earnings for the S&P500, well above their historical contribution of 10-15%. So let’s suppose that financials drop down closer to their historic averages, in the best case. And let’s also assume we’re heading into a timeframe of lower corporate earnings. Both of these take the earnings denominator down and drive the PE ratio up for fixed stock prices.
So what would a cold hearted analysis of this fundamental data suggest? If we keep the 10 year earnings constant but the PE ratio drops well below the historic average and hits 10, the S&P 500 would have to drop from today’s 909 down to 622. If the PE ratio were to drop down to 6, then the S&P 500 would hit 374. If we take the 10 year earnings average down by 20% and the PE ratio to 6, then the S&P 500 would have to hit 299, a 67% drop from the Oct. 8, 2008 close.
Markets usually are driven more by emotion and “common thinking” (as erroneous as that may be), but if one believes in fundamental measures, we could be looking at precipitous drops from here.
Further, common thinking is that the market always bounces back relatively quickly from bear markets. Just listen to those talking heads. But historical data (see the chart below which shows the inflation adjusted S&P 500 index, also from Shiller’s web site) clearly shows that it takes 20 years to recover from major dips (1906 to 1928, 1929 to 1958 and 1969 to 1993).
One can never predict “common thinking”, emotional reactions, tipping points, or the market, but this look back at historical data suggests we could see a 50% drop from here on the S&P 500. Believe that? Then short SPY. The tipping point regarding bounce back time for stocks may be here (again). I’m short SPY and when the PE drops well below 10, I’ll cash out. And I won’t be in a hurry to jump back in.
Disclosure: Author holds a short position in SPY
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This article has 17 comments:
Waiting for a falling market to stop falling before buying is usually prudent advice. Even after the bottom is in there will probably be retests of the lows that offer good buying opportunities. No need to be in any rush.
Where Are We in the Stock Market Cycle?
to put your arms around what the possibilities are for the market.
seekingalpha.com/artic...
economix.blogs.nytimes.../
www.jugglingdynamite.c...
But it doesn't mean we can't have cyclical bull markets between now and when S&P500 P/E bottoms out (around 6 or so).
According to the latest article about this topic at online.wsj.com/article... the TTY SPX PE was 15 as of Oct 10. It was 20 in August.
Many thanks in advance..
Cheers,
Matt Blackman
Wait, are you seriously trying to imply simply looking at past historical P/E lows and making the assumption out of thin air we will revisit lows is a "fundamental measure"? No valuation metrics, no deep thoughts, just simple "it's happened before thus logically it must happen again, and probably this week". You're reading charts and are trying to fool people that this is "fundemental analysis". Unbelievable.
Thanks for the comment. As I pointed out, we all know that markets move on a combination of factors -- fundamentals, sentiment, earnings projections, overall world and local economics, etc. The fundamentals are that PE is still historically high and that earnings estimates are falling. Additionally, sentiment suggests things are as bad or worse that the early '80's and world economics are being bludgeoned by the credit and banking crisis.
Given that, is it out of the question that we hit PE ratios similar to the '80's? No, and that suggests SP500 in the low 400's. If it's as bad as the '30's, then it's in the mid 350's.
After writing the above article, I went long with ultra etf's for a while. Then went back to ultra short etf's as the "bear rally" looked to be running out of steam.
Ron
Sorry for the delayed reply. Here's the site for the latest SP500 earnings data:
www2.standardandpoors....
You can download an excel spreadsheet with the total SP500 earnings as well as the sector breakdown. Then use the same smoothing formula that Shiller uses in his spreadsheet. Note the time delay.
Ron
You're right, lowered earnings for a year or two don't pull the 10 yr average earnings down by much. The main point of the article (which I may not have made a clearly as I should have) is that if the economic times we're heading into are really as bad or worse than the early '80's, then it's not unreasonable, as a "value investor", to think that the PE ratio could go as low as that of the early '80's, which would bring the SP500 down into the 400 range.
Thanks for the comment,
Ron
I agree, no need to be in a hurry to go back in long, just play the short side for a while -- we're now below the mean, but it's unlikely to stop there. Perhaps one sigma below the mean? That would take us to 604. How about 1 1/2 sigma?
Ron
Thanks for the reference to your technical analyis. After what could be a bear rally, we're heading down rapidly toward your level 2 support level. What's your take tonight?
Ron