In the past few months, the S&P 500 has both hit a 13-year low and rallied some 40% off of that point.
Given that volatility, the questions on many people's minds include:
- Is this rally real, or are things going to collapse again?
- If there is another collapse, how far down can it go?
- What should I be doing?
While there are signs that the economy may be considering recovery, the underlying problems haven't been solved yet. And that means no one can really predict what's going to happen from here.
But according to data collected by Yale University's Dr. Robert J. Shiller, of Case-Shiller index fame, an S&P 500 index level of 330 is not entirely out of the question.
Now that I have your attention
Yes, I said "330," as in a 65% drop from here.
In his book Irrational Exuberance, Dr. Shiller collected more than 130 years of S&P 500 index, earnings, and inflation data. He then looked at inflation-adjusted index prices and earnings and calculated 10-year price-to-earnings ratios.
That is, he used a 10-year earnings average to smooth out the highs and lows from normal business cycles, leaving just the bubbles. And when he looked over time, he found the following:
|
Position in Cycle
|
Year
|
Adjusted 10-Year P/E
|
|
Peak
|
1901
|
25.24
|
|
Trough
|
1920
|
4.78
|
|
Peak
|
1929
|
32.56
|
|
Trough
|
1932
|
5.57
|
|
Peak
|
1966
|
24.06
|
|
Trough
|
1982
|
6.64
|
|
Peak
|
1999
|
44.20
|
|
Today
|
End of May 2009
|
15.53
|
Source: IrrationalExuberance.com, run by the Cowles Foundation for Research in Economics and International Center for Finance, Yale University. Includes updated data.
Over the past century or so, there were four major bubbles, with peaks in 1901, 1929, 1966, and 1999. The average adjusted 10-year P/E for the bottoms coming down from the first three is 5.66. For the S&P 500 index to reach that level, it would have to fall to 329.
What would a 65% drop mean for some of the biggest names in the S&P?
|
Company
|
Recent Price
|
65% Drop
|
P/E After a 65% Drop
|
|
Altria (NYSE: MO )
|
$17.35
|
$6.07
|
4.10
|
|
Amazon.com (Nasdaq: AMZN )
|
$79.77
|
$30.48
|
19.54
|
|
McDonald's (NYSE: MCD )
|
$59.08
|
$20.68
|
5.40
|
|
Procter & Gamble (NYSE: PG )
|
$52.41
|
$18.34
|
4.19
|
|
Wells Fargo (NYSE: WFC )
|
$25.66
|
$8.98
|
11.82
|
The world is not ending!
Looking at those prices, you might think so. But even recognizing that the market may reverse course again and hit lows that we sweat to think about doesn't mean you should avoid the market.
Really.
Dr. Jeremy Siegel of the Wharton School of the University of Pennsylvania has demonstrated that the stock market is the best long-term grower of wealth -- better than cash, bonds, or even gold, no matter what kind of volatility, bubbles, and crashes we endure along the way.
And that means you need to be in it. Always. Even when we're looking at the possibility of unprecedented lows.
Take advantage of it -- don't be ruled by it
Many people were surprised by the size of the drop last fall and winter, and many others have been surprised by the surge since March. If you were one of the 17 people who managed to perfectly time the drop and the bottom, congratulations. You can stop reading now.
However, if you are like the rest of us, and you wish to take advantage of the market, whether you're in today or not -- and especially if it drops anywhere near the 300s -- here are three strategies to improve your success at wealth-building.
- Invest with an eye to the long term. Nobody can predict what the market will do in the next year or two, but over the long term, the stock prices of well-managed, steadily operating companies such as Johnson & Johnson (NYSE: JNJ ) tend to rise as their performance grows. In other words, as Warren Buffett's mentor Benjamin Graham once said, in the short run the market is a voting machine, but in the long run, it's a weighing one.
- Move slowly as you enter a position. Since none of us can time the market, entering a position in thirds helps smooth out the inevitable volatility. If you want to invest $3,000 in one position, for example, invest only $1,000 at a time, waiting for other, better opportunities before adding more. This way, if it drops 25% in a week, you can buy more at a better price. On the flip side, if it jumps 25% in a week, you'll already have a stake.
- Stay within your circle of competence. Peter Lynch counseled, "Buy what you know." If you don't understand how a company makes money and what risks it faces, you probably shouldn't be invested in it. Buffett famously avoided technology stocks in the late 1990s, as the tech-fueled dot-com bubble was powered by the likes of Cisco Systems (Nasdaq: CSCO ) . He endured a lot of criticism, but when that bubble burst, he was the one who avoided getting bitten.
The Foolish bottom line
By following these three strategies -- focusing on the long term, investing in thirds, and understanding what you're buying -- your chances of building wealth no matter what the market does tomorrow will be greatly improved.
Motley Fool co-founders Tom and David Gardner have used these strategies in their Stock Advisor investment service, which is currently beating the market by more than 40 percentage points. To see what they're recommending today, along with an up-to-date review of all of their active recommendations, just click here to access a free 30-day trial. There's no obligation to subscribe.
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Jim Mueller owns shares of J&J but had no position in any other company mentioned at the time of publication. The Fool owns shares of Procter & Gamble. Amazon is a Motley Fool Stock Advisor selection, and Johnson & Johnson and Procter & Gamble are Income Investor recommendations. The Fool's disclosure policy can be read in thirds, if need be.
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