The good news: The S&P 500 is trading near fair value. The bad news: If the current post-bubble low follows previous post-bubble lows, the S&P 500 will probably bottom around 600.
First things first, however: Long-term investors can feel better about buying US stocks at the current level than they have anytime in the past 15 years (with the exception of two weeks ago and a few minutes in 2003). As Jeremy Grantham observes, the real mistake for such investors would not be to buy too early but to let stocks get away on the upside again:
[I]f stocks are attractive and you don’t buy and they run away, you don’t just look like an idiot, you are an idiot.
And now that we’ve gotten that out of the way…
We’ve already reviewed Jeremy’s excellent work on the post-bubble troughs for the 1929, 1966, and 1990 Japan peaks (see graphics to right). In each case, stocks bottomed more than 50% below fair value.
In the second half of his quarterly letter, Jeremy puts more meat on this. Specifically, he observes that at post-bubble troughs, both earnings and PE multiples are usually depressed. In each previous huge bubble:
- Profit margins bottomed 36%-39% below the long-term average.
- The PE bottomed 15%-20% below average.
To be conservative, Jeremy uses a profit trough of 28% below average and a PE trough of 17% below average. Putting these two numbers together, you get a market that would bottom about 40% below fair value (vs. the previous 50%) plus. That would mean about 600 on the S&P 500.
It is important to note that, right now, even after a disastrous year, S&P 500 profit margins are still well above average. As the chart at the top of this post shows, history suggests that margins will bottom well below average. This suggests that S&P 500 analysts, who are still predicting double digit profit growth in 2009 are still wildly off the mark. It also suggests that the S&P 500 has yet to see its bottom.
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