Consider other big stock market sell-offs:

• 68% Germany 2000 – 2003
• 68% Japan 1989 – 2003
• 65% UK 1972 – 1974
• 59% Italy 1973 1977
• 59% Spain 1974 – 1979
• 58% France 2000 – 2003

• 83% 1929 – 1932
• 52% so far. October 2007 – present
• 45% 2000 – 2002

The price of a stock (& stock market index) reflects what investors think future earnings prospects are for a company (or stock market index). Then they/we discount future cash flows from earnings to a present value. In the simplest form, we express the current price per unit earnings as a Price / Earnings multiple. 

As you know, the long term P/E average for the S&P500 index (as-reported earnings) is 15. We are much more interested in the P/E of the S&P500 index than the absolute value of the index. Thus, we don’t care much that the S&P500 has lost 51% of its value and that it is trading at a level seen 12 years ago. Actually, we have to care a little, because others in the investment business may be influenced by more emotional aspects (like the market being cut in half). Will the impact of less-rational investors adversely impact the price of a stock or stock market index?  Of course. Do you remember 1998, 1999, and early 2000? The poster child for “irrational exuberance”.  

If we did not have to worry about the impact of other investors (that are more driven by emotion), we’d wait for the S&P500 index to drop to about 420 before buying any long equity positions. This is roughly 12 X our best guess at 2009 earnings of $35. Why 12? Because for too long, the P/E of the S&P500 has been 20 or higher, and we’ll doubtless end up reverting to several years where the P/E is distinctly below 15. 12 feels good. Going all the way to 10 or lower is just too scary (these are typical bear market P/Es).  

Since we have to be aware of the impact of the rest of the investing herd, we have to be concerned with the market rallying from a point higher than is justifiable. Granted if this were to occur, we’d end up seeing several /many years of no stock market gains (just like we’ve done for the past 12 years).

When we buy a stock (or equity mutual fund or ETF) we’re paying a price for a stream of earnings. The fact that the past decade has seen P/E levels markedly higher than the long term average reflects that investors have been willing to pay a higher price for that expected stream of earnings. Investors are probably thinking that way because we’ve just been through the longest bull market run ever. The investing public is expecting this economy & stock market to come racing back – just as it did in 2003-2007. 

Given the fact that we’re trying to stop the global banking system from being wiped out, it is a safe bet we will not manage to dodge every bullet, and that some countries / regions will see severe economic damage – and possibly civil unrest (think in terms of China’s three anniversaries this year: see last month’s newsletter). This will not be good for business and will constrain earnings for years to come. Eventually, investors will change their perspective and will demand higher returns for a given stock price. When this happens, we’ll see the pendulum eventually swing to a period where we go through several years of low P/E ratios.