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"So Much For The Market Being Cheap" Charting A 50-75% Downside Case In The S&P

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July 07, 2010 – Comments (5) | RELATED TICKERS: D , G , TWO

Whether a bull or a bear, here's another article worth reading and contemplating. It compares the price action, trajectory, p/e ratio, and length our current bear market with bear markets of the past. Bottom line: as bad as this bear market has been, it is quite possible that we have a long way to go down from here. Please click on the link to view the graphs mentioned in the excerpt and to read the full article:

"So Much For The Market Being Cheap" Charting A 50-75% Downside Case In The S&P

Historical market data that suggest our current situation resembles very scary periods in times past (i.e., the 1929 crash to be specific) is beginning to pile up.

Let's look at the set up from the perspective of charts.

Here are historical bear markets, indexed to 100% (100% = bull market peak). 

It's quite easy to see that the current bear market that began in late April has been more ferocious than the average bear market through history at this juncture of its development.

In fact, this bear market looks an awful lot like the way the 1929 crash shaped up.  While other individual bear markets have fallen faster and by a greater amount, they were all short-term crashes, such as the 1987 crash and the 1998 Asian Financial crisis crash. 

As such, they ended very quickly.  The current one, however, seems to be more drawn out, again looking very similar to the 1929 crash represented by the red line.



What is worth noting is that despite the fact that we witnessed a mini-crash in May and a $1T support package for Europe thereafter, the current tape action is still as weak as it is and is leading to the set up in these charts I'm discussing. 

Despite the latter events, one of which was supposed to be cathartic to an over-bought market and the other supportive to global economic stability, we're still hanging on the edge of a cliff it seems.



Now, let's specifically compare the 1929-1942 bear market, which began with the 1929 crash and largely ended with US engagement in WW2, to the 2000-2010 period, which has seen two massive bear markets with two major rallies of 100% and 85% in between. 



It is amazing how closely these charts resemble themselves in terms of price action and the timing of each cycle’s respective moves.  It seems to me that the only major difference is the order in which events seem to be playing out. 

For instance, they had their crash quickly while we have avoided ours for 10 years with profligate monetary policy and government spending. 

It seems to me that the market is now recognizing that the game is up; no amount of additional money, bailouts or otherwise can prevent the system from collapsing under the weight of all the debt that has been allowed to build.  That's why it seems as if the far end of the black line is on the cusp of doing what the red line did on the left side of this chart in 1929.

Again, the same events, just reversed - politicians unwittingly took austerity measures in 1929-1930 that caused a depression and they're doing the same thing now, just 10 years later than expected.

If you look at the dotted black line, it represents the absolute low of the 1929-1932 depression, a roughly 85% decline in all on a monthly basis.  For context, this correlates to roughly 230 on the S&P500.

Question is, their bear market ended when we entered WW2; is Iran and Israel the catalyst for a similar situation in 2012 when this analytical work suggests our bear market could end?  They could theoretically pull the world into their mess given the resources at stake and the emergence of a resource rich country in China.

Which brings me to the S&P500 / Gold ratio chart. 

Historically, the value of the S&P500 relative to the price of gold reaches a bottom at roughly 28% (all-time low = 19%).  The ratio is currently 94%. 

Assuming a gold price of $1,500 or $2,000 (reasonable given fundamental backdrop) suggests an S&P500 value of 375-500.



Isn't it crazy to see how the market cycles vs. the price of gold through history?  This is the third major secular bear market for stocks relative to gold over the past 110 years and it shows up decisively in the chart. 

If you believe that everything reverts back to its mean and even overshoots (i.e., when you stretch the rubber band too hard in one direction it has to snap back even harder in the other), then the unprecedented explosion in the market vs. the value of gold in 2000 (almost 6.0 on the chart) relative to other historical peaks at the top of secular bull markets (1929 and 1966) suggests greater upside than $1,500-$2,000 for gold and more downside than 375-500 for the S&P500.

Further, the SPX / Gold ratio chart is where we form our timing thesis of 2012 being a potential bottom for this secular bear. 

Notice how troughs in the S&P500 relative to the price of gold have typically taken 12-13 years to play out.  The S&P500 put its peak in relative to gold 10 long years ago in 2000.  We sure are close.

Let's also look at the valuation on the market (Price-to-Earnings ratio or P/E) when it has typically reached major, major bottoms which have led to new periods of prosperity and huge, secular bull markets.



Typically, the P/E on the S&P500 has reached b/t 6x-8x earnings per share (rolling Shiller 10 year average), well below the current ~19x. 

Notice how the “generational low” in February 2009 (dark black), which preceded the 85% rally over the past year, was probably not the generational low everybody thought it was - the P/E on the market never went below 14x.  Also note the P/E at the 2003 lows (white).

If we assume $70 in S&P500 earnings per share in 2011 (mild recession in 2H10 and 2011) and use a 6x multiple you get an S&P500 value of 420. 

To really nail the overall thesis for you here is a comparison of the P/E ratio on the market during major, long-lasting, secular bear markets.



I’ve indexed the P/E to 100%, the point at which it peaks during the end of a secular bull market.  As the lines move right and lower it represents the amount by which the S&P500’s 10 year P/E has contracted relative to its peak in the past secular bull move.

The black line represents the bear market we've been in since 2000.  The marker represents today's data point. 

As it stands, P/E ratios have contracted by roughly 50% from their level in 2000 (45x, vs. only 35x at the peak in 1929).

Notice how much further valuations have to contract to reach the level of contraction they have reached in other secular bear markets. 

The chart indicates valuations bottom when they have declined about 80%-90% from their high.  Using the 2000 P/E of 45x this yields ~5x-9x, in-line with my chart above which says market bottoms are reached at P/Es in that range.

Let’s play devil’s advocate and assume that S&P500 earnings estimate of $95 (LOL) in 2011 is correct…

Even if it happens, this chart suggests it could be more than offset by material P/E contraction that has yet to take place.  A 6x-8x P/E on that $95 number next year would yield 570-760 on the S&P500, well below the current 1,030.
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5 Comments – Post Your Own

#1) On July 07, 2010 at 1:38 AM, awallejr (85.41) wrote:

The attempts to compare 2010 with 1929 is becoming tiresome.  It is no different than trying to compare say the 1927 Yankees with any present day major league ballclub.  Apples to Oranges.  They didn't have Iphones, or desktop computers, or jet planes, nuclear power, emerging markets, global economic coupling, etc, etc, etc.

We saw the market bottom when we had money freezing and back to back -6 GDP with massive layoffs.  We still see economic expansion, albeit at a slowing pace.  But expansion nonetheless.  Companies continue to show proifts, which, afterall, that is what it is all about.

While I see a trading range, but over time, an upward growing trend, I am not even going to waste time trying to equate what happened EIGHTY years ago to today. That is just silly in my opinion.

+rec to an argued opinion tho heheh.

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#2) On July 07, 2010 at 8:22 AM, russiangambit (29.15) wrote:

The earninings  are looking OK , though. May be expections are 10% or so too optiimistic, but to see a repeat of 1929  we need to see 50-70% fast drop in earnings. What would provide such a shock? Another credit collapse is unlikely in the near future.

I don't really see it. I anticipate more of a slow grind lower with companies adapting to the bad economic conditions in US and Europe but compensating with good buisiness in Asia and emerging markets and earning staying flat to trending lower.

As for the stock market you have a strange situation where on one hand individuals are deleveragining due to retirement and bad employement/ credit situation yet institutions are pouring money in the markets since they have no good lending prospects. That makes for a volotile market driven by institutions.

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#3) On July 07, 2010 at 12:13 PM, chk999 (99.97) wrote:

Yeah, what they said. I can see a jumpy range bound market for a while. I can see some sharp drops and a climb back up to around here or a bit above. I'm having a hard time seeing total collapse.

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#4) On July 08, 2010 at 12:36 AM, awallejr (85.41) wrote:

 russiangambit and I on opposite projections, what else is new heheh.  At least we agree on the 1929 comparison.  But since I am a permabull,  and with all the money printing, and the ridiculously low yields from CDs, Tbills and bonds, I can't see the market not continuing its ascent, even if at a slow, yet volatile, pace. I do like this comment, however: "That makes for a volotile market driven by institutions."

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#5) On July 09, 2010 at 12:15 AM, DarthMaul09 (29.65) wrote:

I mostly agree with russiangambit in terms of the way the US, Europe and Asian markets will act, but I suspect that the current 3 day rise in the market is just the beginning of a brief relief rally that may last for another week or two.  After that, uncertainty about the upcoming elections and the persistent questions concerning real estate and its effects on small banks will probably lead the market lower until at least mid November.

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