How Low the S&P 500 Could Go

The S&P 500 has experienced price level growth in the 1990s through Friday (Oct 10) that is substantially greater than the price growth it experienced in the 40 years after 1950.

We’ve all partied in the growth rates of the last approximate 20 years, but the party may be over.

Is it possible that the index could cumulatively revert to the growth rate channel characteristic of the 1950 to 1990 period?  Yes, it is possible, but we don’t know if it's probable.

With the ongoing growth “handoff” to the developing economies described by El-Erian in his book, When Markets Collide: Investment Strategies for the Age of Global Economic Change; and with the structural problems and changes unfolding in the developed economies, it would not be crazy to consider that the S&P 500 could revert to former, lower price growth rates.

If the index (proxies SPY and IVV) did revert cumulatively to former growth rates, it would be priced generally in the range of less than 900 to more than 400.  That would translate roughly to SPY $90 to $40.

The chart below shows the S&P 500 from 1950 in semi-log format and marks the approximate 1950 through 1990 growth channel with red and green boundary lines extended out to today.

click image to enlarge

SPY closed at $88.50 Friday.  It was over $120 a month ago.  It has been over $150.  If we revert to the general 1950 to 1990 growth rate channel, we could see SPY trading regularly below $90, and in particularly bad scenarios as low as $40.

Another constant growth rate study we did from 1927, also suggested a mean reversion possibility to the general 800 to 400 level for the S&P 500 (SPY $80 to $40).

We are not trying to say the sky is falling, and we are not predicting S&P 400.  We certainly hope prices don’t go that way.  However, we are not willing to deny the possibility of an outcome that presents itself so clearly, simply because it is unpleasant and would be quite damaging.

We must consider all reasonable possibilities and their implications for our investment behavior.

How each investor would deal with that possible growth rate shift would vary greatly, ranging from avoidance through cash or alternative exposure, to hedging, to shorting, to spending it to eliminate the worry.

Post Script:

We wrote the above comments last night, Oct 10, and must admit we felt no small amount of trepidation about making such a dramatic and potentially unpopular statement. It’s tough to be an investment advisor and publish views like that.

The concerns we had were much reduced this morning (Oct 11) when we read the article in the Wall Street Journal by Jason Zweig entitled “What History Tells Us About the Market“.  Here is the except that squares perfectly with our chart-based assertion that S&P 500 could reach the 400 level:

Robert Shiller, professor of finance at Yale University and chief economist for MacroMarkets LLC, tracks what he calls the “Graham P/E,” a measure of market valuation he adapted from an observation Graham made many years ago. The Graham P/E divides the price of major U.S. stocks by their net earnings averaged over the past 10 years, adjusted for inflation. After this week’s bloodbath, the Standard & Poor’s 500-stock index is priced at 15 times earnings by the Graham-Shiller measure. That is a 25% decline since Sept. 30 alone.

The Graham P/E has not been this low since January 1989; the long-term average in Prof. Shiller’s database, which goes back to 1881, is 16.3 times earnings.

But when the stock market moves away from historical norms, it tends to overshoot. The modern low on the Graham P/E was 6.6 in July and August of 1982, and it has sunk below 10 for several long stretches since World War II — most recently, from 1977 through 1984. It would take a bottom of about 600 on the S&P 500 to take the current Graham P/E down to 10. That’s roughly a 30% drop from last week’s levels; an equivalent drop would take the Dow below 6000.

Could the market really overshoot that far on the downside? “That’s a serious possibility, because it’s done it before,” says Prof. Shiller. “It strikes me that it might go down a lot more” from current levels.

In order to trade at a Graham P/E as bad as the 1982 low, the S&P 500 would have to fall to roughly 400, more than a 50% slide from where it is today. A similar drop in the Dow would hit bottom somewhere around 4000.

The Schiller approach is based on fundamental analysis and our was based on inferences from charts, but they both got to the same point.

WSJ making an analysis that shows a downside the same as ours doesn’t make the worst case scenario any more likely, but it does make our conjecture about what could happen just a bit more sound.

Comments

[InvestorDas...:]

Did the same analysis this morning. For the next 30 years, DJIA oscillates between 7000 and 15000 in periods of about 7 to 8 years. Similar to period 1952 to 1983. Pre 1952 was nice bull run. 1983 - 1998 was nice bull run. Post 2038 should be a nice bull run.

2008 Oct 11 01:15 PM

[QVM Group:]

www.qvmgroup.com/inves...

Since posting my article, the WSJ published an article that makes the same worst case S&P at 400 price level analysis from a fundamental perspective. My post is updated on my blog to contain the relevant excerpt form the article by the Jason Zweig of the WSJ.

Modified blog post is at link above.

2008 Oct 11 01:33 PM

[CLH:]

I agree with your article. However, I expect a rally (maybe now which is playable) and then a further downslide.

2008 Oct 11 03:46 PM

[Rcsam:]

Where were you 6 months ago. Negative comments always come out at or near the bottom. You must adjust for inflation and interest rates. The stock market return is correlated with 30 year treasuries. You haver a choice between Treasuries and stocks. The market only needs to provide a 3% premium to treasuries and they are yielding 4.15%. The required return on stocks is around 7% to adjust for the greater risk of equities. The yield is 2.5% on the SPX so growth must be 4.5%. Is that reasonable? Growth is inflation plus population growth plus productivity gains. You would have to forecast no productivity growth which contrary to the American experience for the past 100 years. If the market were 1/2 of today, the yield would be 4.8% and growth would only need to be 2.2% to get to 7%. If inflation goes to 10% like it did in 1975 then you are right as bond yields would go to 13% which is a 3% premium to inflation and the required return on stocks is 16%. You can do the math were the stock market would sell---lower. We do not have 10% inflation nor the prospect of such. More likely we will have deflation.

2008 Oct 11 04:33 PM

[Fighting Yoda:]

************ Too Late to Short Not Too Late to Sell ***********

Yes there is plenty of downside. Markets are about sentiment- that is why we have bubbles and eventual bust. The mood is real bad now- everyone wants the “get me out of here trade”. Redemptions, deleveraging, hedge fund blowups will have an even larger toll.

It does not matter whether S&P actually goes down to 600 or 700 – you do not have to pick the bottom, within +/- 10% of top or bottom is great.

Last week we saw no upside rally – one would have expected especially with all the policy moves. Friday late rally was in financials – we know that sector is only for suckers. This is a very bad sign. With G-7 petering out, next week we should see more of the same.

Only way to play the market is on the short side – sell every rally – we will get one anytime now. At some point down the line start rebuilding the portfolio, ways to go for that.

2008 Oct 11 07:04 PM

[QVM Group:]

RCSAM:

"Where were you 6 months ago. Negative comments always come out at or near the bottom"

Actually, I have been publishing cautionary articles for a long time. I recommend these to you in particular:

1) [Jan 2007] Is the China Craze a Tech Bubble 2.0?

2) [Jun 2007] title: Extraordinary Investment Risks in Russia; OR [Feb 2008] title: Sell Russia

3) [Aug 2007] title: Better Safe Than Sorry [about money market funds that will break a buck]

4) [Sep 2007] title: REIT Mean Reversion Ahead - The 2006 Party is Over

5) [Mar 2008] title: An Ebbing Tide Lowers All Boats [where I said about the US market "when you stand back and look at longer-term patterns, you definitely see a market that’s rolling over."]

There are several other intervening and subsequent warning articles, but these are good date markers.

I do admit to periods of optimism for financials after those warnings that proved unwarranted, and some suggestions that things will get better that have not yet proved true, but I have been a bear for some time, including being 100% cash personally at the end of January 2008 and 86% cash today.

You are correct that the closer we come to a bottom the more the discussion of disaster becomes. For that reason you may be right that a bottom is near -- I hope so -- but you are not correct in suggesting that I am late to the realization that something was going wrong or late in making my view known.


Richard Shaw

2008 Oct 11 10:05 PM

[irondoor91:]

If most people are bullish does that mean a top is near? Not quite, it takes a long time to kill a bull market. But, we've done it now and the bear is in charge. He's not done yet till we find out how many people still have large allocations to stocks in their 401-k's. They'll be bailing out after the air is let out of their bubble again soon.

2008 Oct 12 12:24 AM

[BlueOkie:]

Any data prior to 1963 is unreliable in my opinion. Records were not kept, there were no computers to speak of, and many firms went out of business and we only can guess about them. We talk about SPY and S&P 500. How many firms were in the S&P in 1950 that are there now? What kind of SEC reporting and bookkeeping.

I'm a big fan of Graham, but he didn't have the data available then as we do today. PE's have a problem with how they are computed. i.e. what earnings do you use past, current, future, MRQ etc. Unless you can get inside company books, consistent dividend growth is the best measure for value companies.

2008 Oct 12 11:02 AM

[QVM Group:]

BlueOkie:

You might find my September 2007 article on S&P dividend yield versus interest rates since 1927 more useful.

www.qvmgroup.com/inves...

It shows that stocks were seen as riskier than bonds before 1958, in that they yielded more than bonds before that time. If a similar perception of bonds versus stocks were to come about again, the lower valuation range for stocks might be likely by that metric as well.

2008 Oct 12 11:16 AM

[doc_hawkins:]

I was figuring another 20%
Maybe this makes me a populist but 700B would put a lot of money in the hands of every man woman and child in America. (Its all borrowed though)

Anyway I asked if one had received a stately sum given to them most folks said right off the bat. I'd pay my mortgage.

Hmmm. Banks would get money. Bad loans would be resolved. The people who did not pay back mortage may loose their house and most would deserve it. (People paying off the cost of Chemo we can cut them slack)

Money from the bottom up makes work. Even the bad side of town main pimp who makes bad decisions buys a caddy puts a UAW worker in Detroit to work.

Money who goes to a banker to horde since they make bad decisions makes how many jobs?

Who is better the bad pimp or the bad banker. Both make decisions that destroy lives. Who deserves the money? Why are we borrowing money to give to either.

A former CEO of Caterpillar Inc Lee Morgan stated once
Sales creates jobs.

If the banks see the opportunity they will lend again. If you give the bankers money without a corresponding market they will probably not lend but horde.

Instead of complaining of why the Big banks are not lending we should ask them to explain in one sentence why they are not when the market is flooded with liquidity.

I'm old and I've seen the arguments go back and forth several times and I have seen the results of how the economic engines work under bottom up and trickle down. I do not endorse any one political side but I see plenty of blame.
* One side encourages a group of people to buy things they cannot afford
* Another side comes to power and does not protect said group from predatory lending.
* As Steve Martin said "All I want is a weeks pay for a day's work"

2008 Oct 12 01:07 PM

[Did U Think...:]

Looking for a rally here but the volume will not be convincing IMO and it will peter out in a day or two, reverse, and then lead to a lower low. I really don't know what people are thinking here buying these stocks as we head into a deep recession in 2009 where lots of people must lose their jobs as the excesses get worked out of the system.

This is a great market for gamblers but the wild volatility must be scaring the bejesus out of all the boomers that have their life savings tied up in it. That crowd is a big piece of the money in the market. They have been saving all their lives and now that they want to retire they see their savings evaporating along with their retirement hopes.

I hope boomers are selling into any rally and then just staying on the sidelines until we get the required panic washout.

2008 Oct 13 12:45 AM