Simple Math Says Get Out of the Stock Market

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I want to expand on my 2009 Financial Prediction for the S&P 500.

By the end of 2009 it will hit 633. This estimate is based solely off earnings ($42.26 x PE of 15).

Where did that $42.26 number come from? It is a collection of earnings estimates. Here is a graph that appeared in a recent John Mauldin newsletter.

sp500_estimates

Notice a trend? Historically in every downturn earnings estimates are too high and have to be continually lowered. Earnings are in free fall. Will estimates get lowered again once the horrific 4th Quarter numbers are out? Let us first assume that last estimate of $42.26 is dead on accurate.

Now we need to find a reasonable P/E ratio (price to earnings ratio). What is a good historic P/E in a period of economic contraction? Somewhere between 8 and 15. The 2001 recession had a P/E of around 22, but it was not consumer based. To me that number seems like an outlier. Given that interest rates are so low, I’m more inclined to think a P/E of 15 is fair value, but some think a P/E of 12 is more realistic.

  • $42.26 x 15 = 633.9
  • $42.26 x 12 = 507.12

As I write this post the S&P 500 is at 900. A 900 value would put the P/E at 21.3. I suppose if you think this looks like 2001 and you believe earnings estimates are not going to get lowered again – then buy stock.

However, what if these estimates which keep dropping , drop another 10% before bottoming? That would put the S&P 500 earnings at $38.

  • $38 x 15 = 570
  • $38 x 12 = 456

To be invested in the stock market now, you need to believe that earnings estimates are going to suddenly rise, the economy is going to improve and interest rates are going to stay this ridiculously low.

And to those who still think it is wise to buy and hold during a secular bear market, do the math. What percent of money will you lose in 2009 if your portfolio matches the performance of the S&P 500 and valuation moves to historic norms?

  • $42.26, P/E 15 = -30.0%
  • $42.26, P/E 12 = -43.7%
  • $38, P/E 15 = -38.7%
  • $38, P/E 12 = -49.3%

I’ll play devil’s advocate and throw in a number where the earnings estimates increase by 10% to $46.52.

  • $46.52, P/E 15 = -22.6%

OK, if earnings suddenly increase and interest rates stay this low, then a P/E of 22 might make sense.

  • $46.52, P/E 22 = +13.7%

Note that there hasn’t been a whisper of anyone raising their earnings estimates, so the above number is sheer hope. This is why I preach being in fixed income (savings, CDs, short-term Treasuries). The upside in the stock market is very limited and the downside is huge.

Sitting on the sidelines in 2009 could save you years of retirement income. And if I’m wrong, you can always jump back in the market later not having lost any money. If the clowns on CNBC are wrong, you’ll be working till your 75.

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4 thoughts on “Simple Math Says Get Out of the Stock Market

  1. Nick

    So, there are no stocks that stand to actually increase earnings in the next year? Not a single one?

    Investing in particular stocks is not the same as investing in “the market.”

  2. Nick – how about a challenge? Go find a few stocks you like for 2009 and we will go head to head.

    Here are mine:
    GRZZX 40%
    BEARX 30%
    Cash 30%

    If and when the indexes move to my target, I will go to 100% cash.

  3. Jim

    Nick – The trend is still down, so buying anything long is like swimming upstream …you might make some progress, but it is hard work and you probably won’t get that far.

    MAS – I agree with this post 150%, but with a single caveat …just from a technical perspective it is possible that we get a “rip your face off” bear rally up to 1000 or even 1100 (S&P) prior to the next plunge.

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