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:

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:

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.

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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.