Scenarios for a Stock Market Bottom

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A probability-based forecast for the U.S. stock market between now and 2013 can be constructed using historical relationships between stock prices, earnings and dividends.  This yields a matrix of possible outcomes for the S&P 500 Index over the next two years. 

No matter how dire the circumstances, U.S. stocks always reach a point where the bargains are too attractive to ignore.  The tipping point where sellers retreat and stocks stop going down is ultimately driven by the relationship between stock prices, earnings and dividends.  To estimate where the recent downturn in stocks might bottom out, we can contemplate a range of scenarios for earnings and dividends over the next few years and assign historically valid price relationships to each of these scenarios. 

The result of this exercise is a matrix of price targets for the stock market.  This matrix can serve as a road map for navigating the markets over the next couple of years by providing context for new information as it emerges over time.  For example, downside risk in the stock market will be different if the U.S. economy experiences a mild recession, a severe recession or no recession over the next two years.  A realistic price target for stocks in all three of these scenarios will engender confidence in our investment decisions as new information emerges that makes any one of these three scenarios more likely.

The table below shows the historical relationship between the price of the S&P 500 Index and the average earnings of its component companies over the past 10 years.  This valuation method is frequently called a normalized price-to-earnings ratio (P/E), because it smoothes out the volatility of the business cycle by using a 10-year average for the earnings component of the P/E ratio. The data below is not adjusted for inflation and is based on the post-war period.

Normalized P/E for the S&P 500
1945 – 2011
Average 21.2
Lowest Quartile 9.9 – 15.0
Second Quartile 15.0 – 19.9
Third Quartile 19.9 – 24.5
Highest Quartile 24.5 – 48.6
Current (8-19-11) 21.0
Source:  Standard & Poor’s; Robert J. Shiller; Capital Advisors, Inc.

The good news is that the recent pullback in stocks brought the valuation of the market down to a long-term average of 21.0.  Things can surely get worse from here, but there is no longer a valuation argument for lower stock prices from today’s starting point. We’ve already reached the average, from a valuation perspective.

We can also use the normalized P/E ratio to establish a realistic range of possibilities for the stock market based on the current level of normalized earnings for the S&P 500 Index.  The table below shows where the index would trade at the midpoint of each valuation quartile for the normalized P/E:

Valuation Scenarios for the S&P 500 Index
Based on Normalized EPS of $53.43
S&P 500 Value of 1,123.5
Index Value
% Change
From 8-19-11
Lowest (12.5) 667.9 -40.6%
Second (17.5) 935.0 -16.8%
Third (22.2) 1,186.1 +5.6%
Highest (36.6) 1,955.5 +74.1%

*Note: The index targets are derived from the midpoint of each valuation quartile for the normalized P/E ratio
Source: Standard & Poor's; Robert J. Shiller; Capital Advisors, Inc.