I’ve received a lot of comments on my first quarter market update. As you might recall, I forecasted the bond market was a bear market waiting to happen and the stock market would likely retain its bipolar personality with large swings in the value of the indexes. Both have proven true with bond yields increasing since the first of the year (driving the price of bonds down) and stock market indexes falling significantly and now, over the past couple of days, rallying some. I’ve had a number of folks ask me if I think we’ve seen the lows in the stock market and in a word, my answer is probably not.
There are two things that make me think that. Here they are in very basic terms.
First, as a technical analyst at heart, the long term chart of the S&P 500 is a classic ‘double top’. A ‘double top’ occurs when the index forms two distinct peaks on a chart, forming an M pattern. A ‘double top’ is typically complete when the index declines below the lowest low – known as the ‘valley floor’ of the pattern. Take a look:
This is a monthly S&P 500 chart going back 20 years. You can see that we’re currently in the neighborhood of the market lows of late 2002. While there is a good level of support here (support is a technical term for a price point at which prices tend to stop falling), this chart pattern often results in prices retracing a good portion of the left side of the ‘M’ formed by the chart. If that were to occur, the next support level could be in the 600 range, and then just below 500.
Let’s assume that you’re not a technical analyst, instead your prefer looking at earnings and comparing those earnings to the price of the stock, or in this case the value of the index otherwise known as a price to earnings ratio, where the price of a company’s stock is compared to the earnings of that company as a ratio. For example, if the company’s stock was selling for $20 and the earnings per share were $2, the Price to Earnings ratio or PE would be 20/2 or 10.
Let’s review the average PE ratio of all the companies that make up the S&P 500 historically
(Source: seekingalpha.com)
As you can see going back to 1926, ‘as reported’, P/E ratios have ranged from a low of about 7 or 8 to a high of over 45. According to Standard and Poor, the average PE ratio of the index going back to 1936 when calculated on a quarterly basis is 15.79.
Source/Link: http://www2.standardandpoors.com/portal/site/sp/en/us/page.topic/indices_500/2,3,2,2,0,0,0,0,0,1,5,0,0,0,0,0.html
To complicate this calculation, according to S&P’s early estimates with 65% of the companies reporting, average earnings per share for the last quarter of 2008 were -$3.14 per share with many analysts expecting that number to worsen by the time the remaining companies report. This will mark the first time in history earnings were negative for a quarter. If earnings are negative, a P/E ratio can’t be calculated. So we should look at the year to get a clearer picture of where we are.
According to S&P, earnings for 2008 are estimated to be $29.57 per share for the year and that number may drop before all earnings reports are in. If you doubt what I’m saying, visit S&P’s website; as recently as October their analysts were predicting 2008 annual earnings per share of over $54 and they’re now reducing that estimate by almost half not even 4 months later. The earnings picture is really ugly – in addition to poor performance, many companies are writing off everything they can to try to begin 2009 with as much of a ‘clean slate’ as possible.
Here’s my conclusion about stock market performance based on fundamentals. It doesn’t look a lot different than the conclusion reached above based on technical analysis:
If the S&P 500 index doesn’t move from its current level in the 860 range and we use analysts current earnings estimates for the first 2 quarters of this year, we’ll have a P/E ratio in July of about 36, over twice the historical average. If these assumptions hold true and the market were to revert to the historical average of 15.79, that would mean a correction of over 50% from current levels, putting us in the 500 range once again.
My advice?
We may have a rally before we see the market track down, and in my view there’s a high probability that we haven’t yet seen the market lows. So the old additage – buy low and sell high (especially high on rallies) rings true. Well this concept should sound familiar, in practicality; most folks simply don’t do this.
So how should you be investing?
In our absolute returns portfolio*, we continue to trade market volatility with a strong emphasis on capital preservation. I’d advise you to look into a similar strategy.
Securities offered through USA Advanced Planners (Member FINRA/SIPC). Advisory services offered through USA Wealth Management. USA Advanced Planners and USA Wealth Management are affiliated companies. The opinions expressed herein are those of the writer and not necessarily that of the above noted affiliated companies. This update may contain forward-looking statements, including, but not limited to, statements as to future events that involve various risks and uncertainties. Forward-looking statements involve known and unknown risks, uncertainties and other factors which may cause actual events or results to differ materially from those that were forecasted.
· Absolute return portfolios look to make positive returns whether the overall market is up or down. No investment strategy is 100% accurate. Investing in market related securities involves a risk of principal loss. Prior to making any investment decision, the services of an appropriate professional should be sought as investment related recommendations are dependent upon the personal financial situation of each individual investor.
