How Low Can it Go?

I figure there's a ten-to-one rule that applies to questions. For every client that takes the trouble to call or email me with a question, there have to be ten others who were thinking the same thing, but didn't ask me outright. I got three calls the past two days with the same question, so about thirty others are out there thinking about the same thing.

How low can stocks go from here? We're down 12% from the start of the year already, and we're testing the low set back in November. Do we stay the course? Do we bail out?

Giving the honest answer first: Yes, stocks can go quite a bit lower from here. We have no way of knowing and no way of making a forecast. All we can do is look to the current situation and consult some history.

By our estimation, the S&P 500 at 788 (today's close) represents an under-valuation of about 17%. In the great majority of past eras when stocks could be purchased at this valuation level, investors have been amply rewarded with annualized returns over the ensuing five years of 5% or more above inflation. On that basis, we are quite confident that our investments in stocks will turn out nicely if we are patient.

But, that avoids the question: How low can it go? In the previous two major bottoms (and major recessions), stocks fell to much lower levels. Adjusting everything in terms of today's prices, the S&P500 would have to fall to about 400 in order to match the low of 1982 and 475 to match the low of 1974. Those are staggering numbers, to be sure. When stocks bottomed in 1974, they did so from a valuation peak reached in 1965; fair value was reached in 1970.

The low reached in 1982 wasn't really off of any highs or even fair-value -- stocks bottomed in 1974 and stayed below fair value all the way out to 1990. Sixteen years! That long period of below-trend valuation is what set up the 19 year bull market that ended in 2000.

We are today below fair value off of a valuation peak reached at the end of 1999. We only touched fair value (for the first time since 1990!) in October 2008. We have had an 18-year round trip from fair value to fair value. As a side note: Annualized return over that time? 3.3% after inflation. So much for stocks paying a long-term return of 5-7% above inflation, as some pundits claim. When stocks are bought for fair value, and then sold for fair value, the returns aren't all that stunning. Why? Because corporate earnings growth per share isn't all that stunning.

Now for the important part -- the, "Yeah, but..."

At both of the major market bottoms in 1974 and 1982, inflation was very high. Annual inflation touched 12.3% in late 1974 and hit 14.7% in mid-1980. Inflation had already started to moderate by the market bottom of 1982, but interest rates were still high and corporate earnings were still declining.

At each of the past two major market bottoms, the country was experiencing not only a sharp recession, but strong inflation to go with it. In any economic recovery, we will expect inflation to move higher. What we do not expect is for inflation to run into double-digits and to precede the economic recovery.

So, that is what we are paying most attention to: Will inflation spike above the long-term "tolerance" level of 3-4%, or will it spike sharply higher? Will that inflationary spike occur in conjunction with an earnings recovery, or will the inflation arise before a recovery? If inflation arises too soon, and rises too high -- stocks are in for a hard time. As I wrote in the piece below, we worry about inflation moving above-trend over the medium-range cycle as the economy recovers.

Our outlook, then: We expect any sharp spike of inflation to be short-lived. Unless employment is in a full-bore recovery, we expect the Fed to move quickly to quash any inflation above its policy range. Likewise, we expect any sharp selloffs of stocks driven by inflation worries to also be short-lived.

We do, however, expect a genuine economic recovery to be accompanied by an orderly movement of inflation to somewhat above trend. In the fullness of time, this movement is the one we want to anticipate and protect against, as it will grind down the value of our investments.

As I have written before, an investor can implement strategies to protect against short-term inflation or long-term inflation. But you have to choose which is the bigger concern. You can't really have it both ways. We choose to place modest protections against short-term spikes of inflation (natural resources, energy) and stronger protections against persistent inflation (short bond durations, stocks, real estate).

In sum, stocks can certainly go lower from here. However, we believe any such move will be short-lived and will offer us the opportunity to rebalance portfolios to take advantage of low valuations.