How Low Can Stocks Go?

Between Feb. 9 and Feb. 23, the Dow Jones Industrial Average dropped more than 1,100 points. If it kept plunging at that rate, we'd hit zero before you knew it.

Of course, that won't happen. 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 vodka shots of terror.

At times like this, nobody wants to own stocks. Their palms begin to sweat every time they watch CNBC. They bury 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 17.97 (as of Jan. 30, 2009 as calculated by Standard & Poor's) and a seven-year average of more than 24, and it's pretty apparent that stocks could fall much, much further than they already have, just by returning to the lows they historically hover around 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 could easily mean Dow 5,000, or worse. 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

Coca-Cola (NYSE: KO  )

(30%)

(51.5%)

Akamai (Nasdaq: AKAM  )

(44%)

(65.8%)

Yamana Gold (NYSE: AUY  )

(51%)

(59.1%)

JPMorgan Chase (NYSE: JPM  )

(46%)

(52.4%)

Duke Energy

(24%)

(36.6%)

Google (Nasdaq: GOOG  )

(26%)

(68.5%)

Goldman Sachs (NYSE: GS  )

(46%)

(60.7%)

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 -- are 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 shall pass" philosophy really does work. No matter how bad they get, 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 your side 
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. Duke Energy is a Motley Fool Income Investor recommendation, and JPMorgan Chase is a former recommendation. Coca-Cola is an Inside Value selection. Google and Akamai Technologies are Rule Breakers recommendations. The Motley Fool is investors writing for investors.


Read/Post Comments (7) | Recommend This Article (66)

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  • Report this Comment On February 28, 2009, at 12:50 PM, pireton wrote:

    That article obviously was written by someone with no accounting background. P/E ratios are based on past earnings...not future earnings or historical earnings. Recent "profits" have been horrible. Eventually, they won't be so bad. For JPMorgan to go down to a P/E of 8 would be impossible in these conditions because the liquidation value of the company is far above that. Just selling the buildings and cashing out would result in more money than that.

    The two keys to valuing stocks today are: 1) Liquidation Value...make sure that the stock that you are purchasing almost could be liquidated for the current price...there are an amazing number of companies hovering around that value. 2) Profitability...don't worry about the level of profits today...the system is out of whack...just make sure that the company is profitable...that means that the liquidation value isn't declining. JPMorgan is a perfect example.

    On the opposite end of the spectrum is General Motors...it's liquidation value is extremely negative. It would have to be very profitable for two decades just to return to a positive liquidation value. Even worse, the book value of their PPE (property, plant, equipment) is their biggest asset (of course). Those assets are a problem, not a benefit...no one will buy them and it costs money to shutter them...they have a negative liquidation value even though they are called "assets". Therefore, it is really an impossibility for General Motors to pay off it's liabilities and be left with anything anytime in the coming decades.

  • Report this Comment On February 28, 2009, at 1:06 PM, TMFHousel wrote:

    pireton,

    "That article obviously was written by someone with no accounting background. P/E ratios are based on past earnings...not future earnings or historical earnings"

    Both the table data and current PE data are calculated using the same methodology -- TTM earnings. Past earnings, I'll also point out, are historical earnings.

    "For JPMorgan to go down to a P/E of 8 would be impossible in these conditions because the liquidation value of the company is far above that."

    Impossible? Really? I've yet to see a law saying a stock can't trade below its liquidation value. On the contrary, times of hysterical upheaval prove quite the opposite, which was the basis of this article.

    Thanks for your comments.

  • Report this Comment On March 02, 2009, at 12:58 PM, rrairden wrote:

    "... the best buying opportunities come when investors are scared out of their wits..."

    "And that's exactly where we are today."

    This article was originally published on Oct. 18, 2008.

    S&P500 on October 18 was 940.

    Current realtime quote is 708.

    Looks like everyone plans to wait a while longer before jumping back in.

    Where will we be when the E in P/E goes negative?

    "Hysterical" will be when we see single-day drops of 10 to 15 percent. (Like General Electric today.)

  • Report this Comment On March 02, 2009, at 2:04 PM, KWT8011 wrote:

    This is a simple question, but could you explain why a stock should be "worth much more than a measly eight times earnings"?

    Is there a quick and dirty answer to why it is desirable to pay multiples of earnings?

  • Report this Comment On March 05, 2009, at 8:22 PM, tac42 wrote:

    When will the public realize that being brave and putting money into the market is a lost cause. Sure the stocks sky rocketed after 9/11 but what happened to all those gains? You are no better off now then you were then. We are all being scammed by the banks and the brokers. Wake up and get out of the market and go to Las Vegas or buy a lottery ticket. Market mania is over !

  • Report this Comment On March 05, 2009, at 8:37 PM, kryotex wrote:

    No, the stocks didn't sky rocket after 9/11. In fact, since 1996, the stocks haven't increased at all. My safe cash deposits have increased some 220% since 1996, but stocks have crashed over 65% in general. If your buying stocks right now, even at a dow index as low as 65xx, its only part of a DOWNward trend.

    Remember -Save your capital, don't gamble it. Save it. Safety = safe, not risky.

  • Report this Comment On March 05, 2009, at 8:37 PM, kryotex wrote:

    sell now; invest safely, then consider buying after confidence has returned to the market

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