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:

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:

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.