John Maynard Keynes famously warned that "the markets can remain irrational longer than you can remain solvent." Considering the recent volatility in stocks worldwide, irrationality appears to be the order of the day. Rarely have investors been so prone to bouts of panic selling, punctuated by spasms of equally frenzied buying. The Dow Jones Industrial Average index lost nearly a quarter of its value between Oct. 1 and Oct. 27, including an epic 700-point drop on Oct. 15. The carnage was followed on Oct. 28 by a 900-point rise, the second largest points gain on record.
These wild swings are unsettling. But against the backdrop of virtually unprecedented uncertainty and complexity that surrounds the meltdown of the global financial system, they are not necessarily irrational. They mimic the mind-set of investors who are cycling between greed and fear as they try to assess whether financial stability is returning, and whether the market has reached bottom after a long and costly plunge. Investors are trying to judge whether stocks have indeed become cheap, as some gurus including Warren Buffett have recently argued.
In times such as these, the rational thing to do is to ignore the front-page buzz and listen to what history and the numbers are saying: the odds are that stocks have further to fall, possibly much further. Short-term relief rallies, based on rays of hope that the worst of the credit crunch is behind us, are head fakes, and proof is easy to find. For example, in July, following the legislation to bail out the mortgage giants Fannie Mae and Freddie Mac, the markets rallied for four weeks, only to head south again as investors began to realize that the world (not just the U.S.) was probably entering a recession.
That's where the focus of investors ought to be: not on bailouts or the economic stimulus package du jour, but on the economy itself. All over the world, indicators are flashing red. American consumer confidence and spending have plunged. China's Guangdong province, the boiler room of the global expansion earlier this decade, recently reported its economy in the first nine months of 2008 grew at the slowest pace in 15 years. Most of the G-7 economies have already experienced one quarter of negative growth and will likely experience a recession. Small emerging economies are under serious strain as they seek International Monetary Fund bailouts.
There's no question that hard times are ahead. What is harder to determine is how much further stock prices must fall before recession is fully priced into shares, taking into account weakening corporate earnings. In past severe downturns, when the U.S. economy contracted by 2.5% or more, the average price-to-earnings (P/E) ratio of S&P 500 index stocks has dipped to as low as 10 (the long-term average P/E is 21). From where we stand today, stocks must drop quite a bit more before they reach this historical nadir. How far? Based on 2008 corporate-earnings estimates, the average P/E for the S&P 500 index is currently about 17. Factor in earnings estimates for 2009 — S&P analysts are forecasting average per-share earnings will be $48.52 next year, down from about $55 in 2008 — and stocks would have to drop at least another 30% before they would start to approach the lows of fierce bear markets of the past.
No one knows how long the slump will last or how it will play out. There are plenty of analogies to describe the possible shape of the U.S. downturn if you plotted GDP growth on a graph: V (short and shallow); W (double dip with a positive blip in the middle as a result of fiscal stimulus programs); L (a protracted, Japan-like stagnation); saucer (stagnation with a very weak recovery). A V-shaped recession now seems highly unlikely. The U.S. housing sector continues to deteriorate, eroding consumer confidence and wealth. Private investment is in free fall, and personal consumption (which accounts for 70% of U.S. GDP) is getting weaker and weaker.
This dark outlook augurs a U-shaped recession. The downturn, which began in the fourth quarter of 2007, will be longer than the usual 18 months. The recovery will probably be anemic and for the next few years the U.S. economy is likely to grow below potential. That's the best-case scenario. It suggests that we are many months, and perhaps thousands of Dow index points, from a market bottom.