The farther stocks fall, the cheaper they get–and the higher the expected long-term return becomes. Unfortunately, that doesn’t mean we don’t have a long way to go on the downside.
There were four massive stock bubbles in the 20th Century: 1901, 1929, 1966, and 2000. During each of these bubble peaks, the S&P 500 neared or exceeded 25X on professor Robert Shiller’s cyclically adjusted P/E ratio.* After the first three of these peaks, the S&P 500 PE did not bottom until it hit 5X-8X. We’re still in the middle of the last one.
The most recent bubble peak, 2000, was by far the most extreme we have ever experienced. In 2000, the S&P 500 by prof. Shiller’s measure exceeded 40X (it had never before exceeded 30X). With the S&P 500 hitting 700 today, the PE has now fallen back to 12X. (See chart above.)
Three major bubbles are not enough historical precedent to confidently conclude where the S&P 500 will bottom this time around, but it seems reasonable to conclude that the trough will be in line with–or below–the preceeding lows (Given that we just had the highest peak in history by a mile, it doesn’t seem absurd to think that we might be headed for the lowest trough in history by a mile.)
So where are we now?
Based on Professor Shiller’s latest numbers, we’re at about a 12X P/E. (Prof. Shiller’s last update was at 805 on the S&P 500, which produced a 14X P/E. Plugging in today’s 700 on the same earnings number, we get about a 12X P/E). The 12X PE compares favourably to the long-term arithmetic average of 16X, but it’s still way above the historical troughs of 5X-8X.
So where would the S&P bottom if we hit the previous trough PE lows? It depends how we get there.
If the stock market stops falling and earnings eventually begin to grow again, we would be close to the bottom: The market could simply move sideways for 5-10 years while earnings growth gradually reduced the PE to the 5X-8X range. This is what happened in the 1970s.
Alternatively, the market could just keep dropping, as it did in the early 1930s.
Using Professor Shiller’s latest earnings data, here’s where the numbers would fall out if the market just kept dropping and 10-year average earnings didn’t grow from today’s level:
P/E S&P 500 Level
8X 460 (highest previous trough low)
7X 400 (average previous trough low)
5X 300 (lowest previous trough low)
In short, if the S&P fell straight to the high-end of its previous trough range (8X PE, or 460), it would fall another 35% from today’s level (700)
If the S&P fell straight to the low-end of its previous trough range (5X PE, or 300), it would fall another 55+% from today’s level.
Here’s hoping we don’t set a new low on the downside.
* Shiller’s “cyclically adjusted” PE takes an average of 10 years of S&P 500 earnings instead of using a single year’s. Why? Because the business cycle makes single-year earnings misleading. In boom times, profit margins are high, and P/Es look artificially low (and stocks look misleadingly cheap). In busts, profit margins collapse, and P/Es look artificially high (and stocks look misleadingly expensive–as is the case this year). Shiller’s cyclically-adjusted PE mutes the effect of the business cycle and, therefore, provides a much more informative and predictive PE ratio.
Here’s a link to Professor Shiller’s site, where you can download an Excel spreadsheet with all of the S&P 500 data >
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