Tuesday, January 22, 2008

Prediction: Dow 8500, S&P 940

If the current market crash behaves like the crashes of 1929, 1946, 1961-2, and 1987, then it will bottom-out around Dow 8500 and S&P 940. Not all of the market bottoms in that list were final; in some cases the market paused for several months before falling even further. The low reached in 1929 was only temporary. Several months later the market continued to fall even further but at a slower pace. In 1987 on the other hand, the market nadir was a real one, and it was a golden opportunity to buy back in to stocks.

In terms of economic causes for the current crash, I think there are characteristics which are a mix-and-match of some of those in 1929, 1987, and the 2000 bear market onset.

In 1929 the stock market was overvalued by investors who were allowed to buy $9,000 worth of stock with only $1,000. The economy had been growing quickly in the 1920's, and it was the stock market crash and the resulting loan defaults and bank failures which actually triggered the great depression. Today the stock market is overvalued because corporate stock buybacks have resulted in reduced dividends, (the true worth of a stock) and have artificially inflated prices with additional buying pressure. News of an economic slowdown was already in the air in the fall of 2007, and the slow unwinding was probably the spark which finally triggered the crash that was waiting to happen.

The year 1987 was not particularly bad for corporate profits. Earnings had pulled back a bit in 1985 and were flat in 1986, but they were on the verge of a late-1980's surge. The only problem in 1987 was an over-valued stock market which had nearly doubled in value in just 2 years. After the crash in October of that year, the stock market and the economy both continued on their merry way upwards. If corporations start paying their dividends again, and if the economy doesn't shrink too much, then today's crash could ultimately resolve in the same way.

The year 2000 featured an historically over-valued stock market and a booming economy on the verge of a recession. The over-valuation was due in part to a breakdown in the system of earnings reports and forecasts, which left many investors to believe that profits were larger in both size and rate-of-growth than they actually were. By 1999, "experts" were even trying to convince people that P/E valuation no longer mattered, and that the sky was the limit for stock prices. When the first rumblings of recession began to reveal the lies, investors grudgingly pulled out over the next couple of years. Today the obfuscation is not in the earnings reports or forecasts, but in the idea that buy-and-hold investors still get their fair share of the earnings. They don't, because companies have stopped paying dividends to buy-and-holders in favor of paying day traders to sell their shares.

Coincidentally, a return to Dow 8500/ S&P 940 levels would raise the dividend yield to the 3.0% - 3.5% range, which is finally back in the historically reasonable range of 3% to 6%. The market must at some point return to the even higher 6% yield level, and that would require a drop to Dow 5000/ S&P 460 today. On the other hand, corporations could stop their idiotic buyback frenzy and go back to paying dividends, and that would double the market's dividend yield overnight even if prices didn't change. But I don't think that will happen until Congress or the SEC act to limit corporate buybacks.


Deborah said...

In 1929 there was also a housing bubble...

When you look at stocks it is amazing how many are trading on P/E for earnings from equity gains, at least in the commodities. Indeed, many of the gold producers not making ends meet have been selling off equities in base metal companies when base metals could do no wrong, and then they get traded leveraged to those one time earnings.

You leave out what happens to the dow and dividends should they decline... I can't see how bank stocks ever manage to return to their dividend levels...

I think many companies that haven't had earnings squeeze will have them now...

Jody said...

I agree that declining earnings (and dividends) would make things even worse, but I have to believe that sooner or later companies will be compelled to stop wasting their cash on buybacks. If they stopped their buyback programs today and used the savings to pay the dividends they're supposed to pay, then the dividend yield of the S&P/Dow would more than double in one quarter. (Assuming no price change!)

Sure, banks could be in trouble for a while, but there are plenty of (supposedly) dividend-paying companies that aren't banks.