Too Late to Short SPY? An Historical Perspective

Oct.10.08 | About: SPDR S&P (SPY)

So, the S&P 500 (NYSEARCA: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.

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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