The DOW dropped another 520 points today.
And that’s on top of the 513 points it dropped last Thursday and the ~600 points it dropped on Monday. (Yesterday, it was up ~400, so that helped a bit).
The S&P 500, a broader market measure, is now down almost 20% off its recent peak.
So what does that mean?
Is it a “buying opportunity”?
Over the short-term, the market could certainly snap back violently, the way it did yesterday. And if the carnage keeps up, Ben Bernanke might announce some huge new quantitative easing program in addition to his zero-per cent-interest-rates-until-2013 announcement of yesterday. Or Congress might quickly rethink its recent commitment to “austerity” and announce massive new stimulus spending. And those initiatives might boost stocks for a while.
The bigger picture, however, is still not that encouraging. Even after the recent plunge, stocks are still about 20% overvalued when measured on Professor Robert Shiller’s “normalized” earnings–earnings adjusted to normalize profit margins–which is one of the only valuation measures that works.
Specifically, even after the crash, stocks are still trading at 19X cyclically adjusted earnings. As we can see in the following chart from Professor Shiller, over the past century, stocks have averaged about 16X those earnings. So we’re still about 20% above “normal.”
Importantly, though, 19X is a lot closer to normal than the ~24X recent peak. Stocks certainly aren’t “cheap,” but they’re also not wildly overvalued anymore.
[credit provider=”Professor Robert Shiller” url=”http://www.irrationalexuberance.com/index.htm”]
Wait, what are “normalized” earnings? Aren’t stocks now astoundingly “cheap”?
In recent months, eager to suggest that stocks are cheap, most analysts have talked about the market P/E ratio relative to next year’s projected earnings. And relative to those earnings, stocks do seem modestly “cheap” (12X, or something).
Unfortunately, measuring stock values against next year’s projected earnings has a couple of flaws. First, no one knows whether those projections will materialise. Second, and more important, those projected earnings assume that today’s near-record-high profit margins will persist.
Over history, corporate profit margins have been one of the most reliably “mean-reverting” metrics in the economy. When margins get extended to super-high (today) or super low (2009) levels, they generally revert toward the mean. This radically changes the PE ratio.
Using single-year earnings often provides a very misleading impression of how “cheap” or “expensive” stocks are. When profit margins are abnormally high, as they are now, the PE seems misleadingly low. And when profit margins are abnormally low, as they were in 2009, the PE seems misleadingly high. The “normalized” PE ratio provides a much more meaningful view.
And measured on average profit margins, not today’s super-high margins, the stock market is still a bit expensive. (We discuss this in detail here).
Sadly, this doesn’t tell you anything about what the market will do next. As you can see in Professor Shiller’s chart, the market has spent decades above and below the average.
What this PE ratio does tell you is that stocks still have lots of room to fall–20%, just to get back to normal, much more than that if they “overshoot.”
And it also tells you that long-term returns are still likely to be sub-par. Through history, one of the most reliable predictors of next-10-year returns is the valuation level at the beginning of the period. Today’s valuation level is not as high as yesterday’s. But it’s still higher than average.
But we’re getting closer to “fair value.” And that’s good news for long-term investors who want a compelling long-term return.
See Also: Here’s Why The Stock Market Is Screwed