There is no shortage of opinions on where the bottom of this market is from “analysts” on TV. It seems the more loudly you speak and the more zany you are, the more likely the public will be inclined to believe you. The poster child for this is Cramer on CNBC TV. I am also intrigued by the clear bias of TV commentators towards painting an overly rosy picture. There were talking heads being interviewed at all levels of the market decline that were pounding the table telling viewers to get back into the market –or stay in – because with the market down 10, 20, 30, 40%, it is clearly a buying opportunity. To this I say – bull (or maybe more appropriately – Bear!)! Heed these cheerleaders at your peril. 

A stock, bond, or market index does not represent value because it has dropped in price. It may represent a value if its price is perceived as low versus its intrinsic value or calculated market price based on discounted future earnings (in the case of a stock) / cash flows.

All year I have been writing about fair value on the Dow and /or S&P500 index. Earlier in the year I wrote that the S&P500 might be fairly valued around 1050 (it was 1530 in October 2007). Then I lowered my view to around 950 a few months later, then 850. Some may ask why can’t I make up my mind? Fair question. The reason for the steady slide in my projection of fair value has to do with the underlying mechanism for calculating fair value. The value of an index (be it fair or not) is based upon the sum of the earnings (for 1 year) for the companies in the index. This earnings figure is then multiplied by a multiple that may be associated with calculating the market value of an enterprise. This multiple is called a Price/Earnings multiple (P/E). Multiply these two figures and you and up with the value of a stock – or in this case a market index.
Since the earnings prospects for companies in the S&P500 (for example) have slid rather violently – almost cut in half over the past 12 months – the value of the S&P500 index should rightfully be sliced in half (from 1500 to 750). Add to this the P/E multiple being reduced from a figure that was far too high and you see where I can justify much lower valuations on the Dow and S&P. 

 

Here is where we were in October 2007: S&P500 was at 1550. Earnings were around $86. Hence the P/E multiple was 18 (1550 / $86 = 18). Compare that to October 2008. We have estimated 2009 earnings at $48.
 

How to interpret this data:

  • The simplest and easiest to defend is a pure recalculation of the index using the same P/E multiple of 18. This gives us an S&P500 index value of 864. (It is 1000 as I write this).
  • Now add some interesting factors. What if we were to use the long term average P/E of the S&P500 (it is 15)? Result: S&P500 = 720.
  • What if we use a repeated long term bear market low P/E of 9? Result: S&P500 = 432. Still not scared? How about if we also factor in the fact that earnings estimates have plummeted at an alarming rate of the past year. What if earnings estimates drop another 10% (not a reach at all) to $43. $43 X 9= 387. Reality check: Toyota cut its profit forecast in half!!! (not in the S&P500 but a very well run company to be sure).
So where is the bottom (of the broad US Stock market)? You can rationally defend an S&P500 value of anywhere from 387 to 864. Given that the industry is set-up to be biased towards spinning things overly rosy, and given that every central bank has thrown everything including the kitchen sink into propping up currency markets, credit markets, stock markets, banks, stimulus package 1, stimulus package 2 etc, we probably won’t see the low end of the spectrum. Given that October saw the S&P500 at 839, it is a fair assumption to say the S&P500 may see a final bear market bottom around 750 (10% lower than the low we hit a few weeks ago). Note: if all the actions taken by central banks do not ward off a catastrophe in the credit markets, we probably will see an S&P500 at 400-500 after all. We should know the answer to this question by the end of the year. 

There is another variable I did not introduce. Given the technical nature of this article so far, I hesitate to complicate things further. But this point is key. If we were to use reported actual earnings (including supposed 1-time special (bad) events) instead of operating earnings, we would lower the above numbers further.

I will assert that the larger the gap from where this market bottoms out versus the numbers shown above, the more dead weight/baggage we’ll have to carry on the way up. This will suppress stock market gains in the coming years unless we wash out all the bad stuff and bake that into current market valuations.