How Big Will the Market Pullback Be?

| About: SPDR S&P (SPY)
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Even after the recent pullbacks, on Tuesday, August 18, 2009, the market was up 44% since it bottomed on March 9. Most of the buzz is that it is overbought and ready for a pullback. Two distinct opinions on this pullback exist:

  1. Bulls: It is a natural resting period as stock consolidate their gains and then go on to new heights.
  2. Bears: The runup is identical to the 1929 stock market recovery and we are about to drop 70%.

Over time, the stock market reflects the earnings of the individual companies, so an understanding of the likely direction of the market can be had by looking at earning trends and how the market reacts to them during recessions.

The chart below shows selected S&P500 annualized data from Robert Shiller’s Irrational Exuberance site which goes all the way back to 1871. Shown are the 2 relevant market declines from the top to the final bottom: The 1929 drop which was the last deflationary pullback and the 2000 drop which is most similar to what the Bulls say is about to happen today. It’s easy to see that both Indexes followed the declines in earning.
S&P500 Index and Earnings

S&P is nice enough to provide estimates of future operating earnings at their site so let’s use this to see what is likely to happen (note this data is quarterly instead of monthly which makes the charts jagged and shifts the market tops).

The chart below compares the current decline which started in the second quarter 2007 with the decline that started in the first quarter 2000. S&P earnings estimates are used for the third quarter 2009 on.

In 2000-2003, the market declined 29% after earnings bottomed in the fourth quarter 2001. If we assume that the bottom in earnings will occur in the third quarter 2009 as the S&P currently estimates, we can expect a similar decline from today down to approximately 650.

Quarterly S&P500 Index and Earnings
The current earnings decline is much greater than that of the 2000 pullback, 59% versus 28%, but the absolute bottom in earnings is similar, $38.38 versus $38.85, so a bottom similar to 2002 of around 800 might be projected. Note that the S&P estimates assume a V shaped recovery in earnings that is much steeper than what occurred in 2001-2002. This is contrary to what most economists are predicting, so if you’re a conservative forecaster, the 650 would be no better than your mid-point estimate of the market bottom. Your forecast of how low the market may go is dependent on how bad you think the current economy is and when corporate profits will recover.

Obviously, we don’t know where the market will bottom but a sharp pullback from current levels is almost certain to occur. Testing the old low appears a certainty while going below it is likely if corporate profits decline more than current estimates. Unfortunately, analysts have been overestimating earnings for the last two years.

We'll see.