How low can you go?

A lot people are wondering how bad the stock market can get.

I don’t know how low it will go, but I have a pretty good idea of how low it can go.

Before I outline my reasoning, let me forewarn you: the answer is ugly.

I’m not trying to predict what the market will do or when–no one really can. I’m just trying to prepare you for the worst case scenario just in case it happens.

You don’t want to sell at the bottom. Nothing will hose up your long term goals as much as going to cash in hopes you can sell at the top and buy at the bottom. The odds are highly in favor of you doing just the opposite–most people do. Knowing how bad things can get may help you avoid selling at the bottom, and that’s what I’m trying to do in this blog.

The reality is I’ve never been as bullish as I am now. I’m projecting the highest returns going forward I’ve seen in 13 years! I’m terribly excited about the returns I believe I’ll get over the next 5 years. But, and there’s always a but, the stock market could go a lot lower before it goes back up again.

How low? History indicates the market can get as low as 7 times normalized earnings. I’ve talked about normalized earnings in the past, but let me explain it again briefly.

The stock market’s per share earnings have grown quite steadily at around 6% a year over the last 50+ years. In boom times earnings are above this trend, and in bust times earnings are below. But, over time, the earnings always return to trend.

Such earnings are like true north to a navigator. They point the way in all circumstances and provide a ready reference for where you are and where you’re going.

That’s why I use normalized earnings–it’s a steady guide. In boom times, the stock market sells at over 20 times earnings. In bust times, it tends to go down below 10 times earnings. In the worst times, it gets down to around 7 times normalized earnings.

What would 7 times normalized earnings mean for the S&P 500? Normalized earnings in the next year for the S&P 500 will be around $67 a share. 7 times that gives you a value of $469 for the S&P 500, roughly 52% below today’s closing price of around $970 on the S&P 500. That would correlate to a Dow Jones Industrial Average of $4,500.

I’m not saying we’ll get that low. In fact, I consider that quite unlikely. I’m not saying I want to see it go that low–I’d feel terrible if it did. But, I am saying be prepared for it to go that low just in case it does.

Benjamin Graham, the father of value investing, once said you shouldn’t invest in the stock market unless you’re ready to see your investment cut in half and double in value. I agree with that sentiment. Be prepared for the worst, hope for the best.

On a brighter note, the stock market usually trades at an average of 15 times normalized earnings. That would mean an S&P 500 of around $1,000 and a Dow of $9,600. In other words, the market is already below fair value.

The problem is the stock market almost always goes below fair value after boom times. It already has, but could go lower still. Be prepared for how low it can go and don’t sell at the bottom.

Like I said above, I’m finding the best values I’ve found in years. Great companies are selling at prices that are likely to generate very high returns over the long run. Even if things go significantly lower, this is an absolutely great time to invest!

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.