Will Tomorrow be the Day?

I don’t pay much if any attention to the Dow Jones Industrial Average (DJIA).  The Dow is the oldest index and is very widely reported, but it only covers 30 stocks and, like the name implies, only from one sector of the economy.  While the Dow has moved to new lows, I’ve been watching the S&P 500.

Within my business, the S&P 500 is more widely watched.  It covers 500 stocks, from all sectors of the economy, and represents approximately 75% of the total market.  As such it is an excellent, broad barometer of investor confidence.

On Oct. 7, 2007 the S&P hit an all-time high of 1576.09.  Since then the intraday low was reached on Nov. 21, 2008, at 741.02.  That’s a decline of 52.98%.  Today, the S&P closed at 743.33, but traded as low as 742.37.  So, the Nov. 20, 2008 low still holds, for now.

I heard a report today that “consensus” earnings estimates for the S&P 500 for 2009 are now 50.  If you put an “average” P/E on that you get a fair market value of 750.  Using that metric, the market is now fairly priced.

However, markets tend to over correct.  Bear markets traditionally do not end until the P/E is under 10.  If that holds true this time we can get to that 10 P/E in one of two ways.  The most painful would be a continued decline in the markets; a P/E of 10 on earnings of 50 is a value of 500 on the S&P.  This would represent a drop of 68.28% from the Oct. 7, 2007 high.  Brutal, but not unprecedented; the NASDAQ dropped more earlier this decade.

The other way to get to a P/E of 10 would be for a lengthy sideways market.  If we trade in a tight range, the price will remain somewhat constant and eventually earnings will increase, thus reducing the P/E.  It might not be until next year, but earnings will rebound.  This scenario has been my operating model.

The rapid deterioration in the markets over the past few weeks, however, is putting serious strain on this model.  Tomorrow’s movement will be telling.  Will we hover around a “fair” price of 750 or will we over correct and start the fall to something as low as 500?  What will the animal spirits compel investors to do?  What theory of behavioral investing can we summon to guide us?

No one knows.

Advertisements

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s