How Low Can Stocks Go?

Between Jan. 6 and Jan. 20, the Dow Jones Industrial Average dropped more than 1,000 points. If it kept plunging at that rate, the index would hit zero in a matter of months.

Of course, we won't see zero. No matter how ugly the markets get, the pain we saw over these past few months can't continue for long.

But here's the bad news: Even though zero is out of the question, that doesn't mean stocks won't plummet from here. In fact, they could fall much, much further.

And history agrees. 

What goes up... 
The history of long-term market downturns is pretty abysmal. When times are bad, markets don't just get drunk with fear -- they start downing entire vodka shots of it.

At times like this, nobody wants to own stocks. Investors' palms begin to sweat every time they watch CNBC. They hide their heads in the hope that the pain will go away. They throw in the towel and sell stocks indiscriminately. In short, everything gets ugly.

Just how ugly? Have a look at the average price-to-earnings ratio of the entire S&P 500 index over these three periods of market mayhem:

Period

Average S&P 500 P/E Ratio

1977-1982

8.27

1947-1951

7.78

1940-1942

9.01

Compare that to the average P/E ratio today of 19.59 (as calculated by Standard & Poor's) and a seven-year average of more than 24, and it's apparent that stocks could fall much, much further than they already have, just by returning to the lows around which they historically hover during downturns.

Assuming that earnings stay flat, revisiting those historically low levels could easily mean a nearly 50% decline from here. For the Dow Jones Industrial Average, that'd correlate to roughly Dow 5,000 -- give or take. Of course, I'm not predicting, warning, or forecasting -- I'm just taking a long look at history.                            

But what if it did happen? 
What would happen to individual stocks? Here's what a few popular names would look like trading at P/E ratios of 8:

Company

One-Year Return

Decline From Current Levels With P/E of 8

PepsiCo (NYSE: PEP  )

(26%)

(44%)

Oracle (Nasdaq: ORCL  )

(22%)

(48%)

Microsoft (Nasdaq: MSFT  )

(41%)

(22%)

Yahoo! (Nasdaq: YHOO  )

(44%)

(54%)

Amazon.com (Nasdaq: AMZN  )

(37%)

(77%)

Monsanto (NYSE: MON  )

(26%)

(58%)

Walgreen (NYSE: WAG  )

(22%)

(36%)

Look scary? It is. And it could easily happen.

But here's the silver lining: Every one of those stocks -- heck, the overwhelming majority of stocks -- is worth much more than a measly eight times earnings. The only thing that pushes the average stock to such embarrassing levels is an overdose of panic, rather than a good reading on what the company might actually be worth. 

Be brave 
As difficult as it is right now, following the "this too will pass" philosophy really does work. No matter how bad it gets, things will eventually recover. Those brave enough to dive in when no one else dares to touch stocks will end up scoring the multibagger returns.

Need proof? Think about the best times you could have bought stocks in the past: after the economy recovered from oil shocks in the '70s, after the magnificent market crash of 1987, after global financial markets seized up in 1998, and after the 9/11 attacks that shook markets to the core. As plainly obvious as it is in hindsight, the best buying opportunities come when investors are scared out of their wits and threaten to give up on markets altogether.

And that's exactly where we are today.

Pick what side you'd like to be on 
The next few years are likely to be quite a ride. On the other hand, the history of the market shows that gloomy, volatile periods also provide once-in-a-lifetime opportunities that can earn ridiculous returns as rationality gets back on track.

If you need a few stock ideas, our team at Motley Fool Inside Value is sifting through the market rubble to find those opportunities. To see what they're recommending right now, click here to try the service free for 30 days. There's no obligation to subscribe.

This article was originally published on Oct. 18, 2008. It has been updated.

Fool contributor Morgan Housel doesn't own shares in any of the companies mentioned in this article PepsiCo is a Motley Fool Income Investor selection. Microsoft is an Inside Value pick. Amazon.com is a Stock Advisor recommendation. The Motley Fool is investors writing for investors.


Read/Post Comments (15) | Recommend This Article (56)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On January 23, 2009, at 5:04 PM, dfrndez wrote:

    Where is the current P/E for the S&P listed? The SPY index for the S&P 500 notes a P/E of roughly 10.23 as of December 08, which may then be linked to the operating earnings as oppose to "as is", but the quoted P/E above of 19.6 still sounds fairly high. Is there a link to this data on the S&P, I saw posted only the third quarter P/E for 2008.

  • Report this Comment On January 23, 2009, at 5:08 PM, TMFHousel wrote:
  • Report this Comment On January 24, 2009, at 1:41 AM, TimothyVR wrote:

    Has the p/e fallen since then? The 19.6 figure is for the end of December.

    Interesting article. I am still very new to all of this and it would seem that this p/e information, which is so important, is very difficult to find.

    It would seem based on the information here that p/e ratios fell below ten only a few times in the last century.

    I am reading Phil Fisher's book "Common Stocks and Uncommon Profits". He talks about the intense fear that takes over during times of very low p/e ratios, and the buying opportunities. Still, he advises caution.

  • Report this Comment On January 24, 2009, at 8:36 AM, 181736065 wrote:

    Good article Morgan.

    But you forgot the "most frightening" part:

    If we enter long term "stagflation", or the morass Japan has found itself in, then we may not see a recovery for at least two decades.

    All these are close to "worse case" scenarios (not ones that I necessarily believe in). And they must be considered by any responsible investor.

    BTW, you addressed just a P/E drop - not a most likely reduction on earnings!

    How could psychology turn so opposite where it was two years ago? Interesting.

    Bill J.

  • Report this Comment On January 24, 2009, at 1:55 PM, venkytalks wrote:

    PE ratios have no value in a scenario of earnings degrowth. Just as one accepts a high PE ratio for growth stocks, if what one anticipates is an earnings degrowth, then bery low PE ratios are justified.

    Low PE ratios persist in long recessions, because of year on year fall in revenues and profits.

    Until we see some clarity in the extent of market destruction for various companies, depending on SP500 PER for making investment decisions would be fool hardy

  • Report this Comment On January 25, 2009, at 3:24 PM, trueredandblack wrote:

    If your an active trader, going sideways isnt such a bad thing. But our economy has fundamentally changed. Instead of people borrowing and spending more than they can afford, they will now have to spend what they can earn. With unemployment rising, and the #1 investment of 75% of the US having been cut in half (their home), people can no longer use a refi as a source of income (no equity left in their house). However, I believe all of this has already been priced into the market. 7,500 will be touched again, then were going north.

  • Report this Comment On January 26, 2009, at 2:27 AM, rp666 wrote:

    >markets don't just get drunk with fear -- they start downing entire vodka shots of it.

    Whoever heard of drinking partial shots?

  • Report this Comment On February 17, 2009, at 8:16 PM, jlondonace wrote:

    from a slightly different perspective...

    marketing/advertising..

    consumer confidence seeks confirmation...

    mental "visualization" ...

    i see/ i can/ i will/ i am...

    process / product of connecting to intuitive link...

    perception /possibility /probability...

    identity...defined enrichment...

    mayhem absolute come..built playing card houses. when the butcher, the baker, etc. let stock rule their conversations...the parade had passed...

    economics...not best understood card in their deck...

    same with following substitute alternate...housing boom...

    what once was a fair market price for a house..?

    20% above the construction cost...not 200%.

    "I'll get it if i can...!"...

    pragmatic replaced with attending to greed...me'ism...

    truth is...our own exasperated breath blew before we built it...anxiety becomes product of deeds done...

    so where do we go next...?

    parade marches backward..

    feint of heart reality..try beginning /process not based upon "quick" / "braggadocio" / unethical...

    your last true breath clears the site...

    return to a 6000 dow was in the cards as we all built..

    probably just another product of a "service" and accepting "debt" as a measurement of "credibility"... economy of the absurd...

    self limiting...

    what will take it's place...?

  • Report this Comment On February 18, 2009, at 3:12 PM, allegra wrote:

    Isn't this what we have been waiting for? The "blood on the streets" scenario, where all sellers have been shaken out and buyers are too terrified to buy? I thought THIS kind of panic marked the bottom. Stocks going sideways because there are no more sellers until, gradually, the cash- hoarding misers come in. We've been waiting for the testing of the lows for months now. Why so glum? I think by year's end the buyers will be back. The market is a leading, not a lagging indicator.

  • Report this Comment On February 18, 2009, at 5:36 PM, lucybluebear wrote:

    I have seen my 401 fall around 40% and have not converted it to cash. Should I ? I am thinking about converting my current investment to cash but continue to buy mutual funds with my bi-weekly contributions. Is it too late?

  • Report this Comment On February 20, 2009, at 9:30 AM, Wisconsinite wrote:

    lucybluebear.. don't sell!! buy low, sell high.. not the other way around. Your 401k is the last thing you should ever liquidate. Its stinks to watch the numbers drop, but depending on your age and retirement the only thing you might want to look is changing your investment percentages within your 401k to match where you are in life.

  • Report this Comment On February 20, 2009, at 6:29 PM, lucybluebear wrote:

    thanks Wisconsonite for your support. I hear friends at work who moved their 401k money and say they only lost 10% in 2008. And I hear rumors of the Dow going to 5,000. I still have some years before retirement, hopefully less than 10, but I can not at least consider moving some of the 401k to a much, much more conservative approach. I can see future purchases being aggresive. But what to do with my current investment...

  • Report this Comment On February 26, 2009, at 5:21 PM, Fabonz wrote:

    I love the "don't sell.....now is the time to buy" mentality.

    Yes, we all understand that the point is to buy low and sell high. Problem is that there is no objectively accurate way to tell if prices are "low" now. There are quite a few of us that beleive we will see 5000 DJIA before we see 10,000 again.

    The time to sell "high" was in September 2008. The time to buy low will be on the day everyone decides the pain is too great and just gives up on the market (capitulation). We have not seen that happen yet.

  • Report this Comment On February 26, 2009, at 5:29 PM, Fabonz wrote:

    And by the way....

    What in the heck is wrong with holding a lot of cash in your 401K? I had a pretty good 6 year run of high returns. When the clouds started to gather I started to gradually get out of stocks. Didn't save it all, of course, but I managed to get to all cash only losing about 12%.

    You can always "buy it all back".

    Does anyone actually think I am going to miss the "big move up" by so much it will cost me more than I already saved by missing the big move down?

  • Report this Comment On March 09, 2009, at 12:10 PM, Redrocktom wrote:

    In the period 1977-1982 there were delicious alternatives to holding stocks. You could buy treasuries of any length paying over 10 percent! I myself actually bought an FDIC guaranteed CD that yielded 16 percent.

    Today there is no such alternative.

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