March 10 changed everything.
That's the day we started this stock market rally. In the months leading up to that day, everyone I knew was wondering how much worse it could get, and speculating on when we'd see a bottom.
Now, that fear and paralysis has given way to a feeling of relief and reassurance. The stock market is up almost 40%, and consumer confidence is skyrocketing.
Even the downtrodden banks have been getting good news. We actually saw accounting-aided quarterly profits from many of them, including two of the weaker big banks: Citigroup (NYSE:C) and Bank of America (NYSE:BAC). Meanwhile, stronger banks such as JPMorgan (NYSE:JPM) and Goldman Sachs (NYSE:GS) are on the verge of paying back their TARP loans.
While it's been nice to be able to peek at our 401(k) returns again, things haven't changed that much in three months. Our near-10% unemployment rate and faltering GDP should tell us that.
As such, it's wise to step back from the rally and assess how much more pain is possible.
How much more can housing prices fall?
The bursting of the housing bubble started this whole mess. Falling home prices begat the destruction of bank balance sheets, which begat the crushing of our economy and stock market, which begat the tears of this clown. Our economy won't recover until the housing market stabilizes.
Since peaking in the summer of 2006, housing prices have fallen 32%. For an asset that some thought would never fall in value, that's a huge drop. Yet housing remains 40% higher than it was in 2000. A decade's worth of inflation and the government's efforts to provide a housing floor should help, but remember that just as we overshot fair value on the way up, there's the possibility that we could overshoot on the way down.
With the qualifier that the housing market really is highly localized, average national home prices still have room to drop.
How much more can stock prices fall?
At its March lows, the stock market was down 55% from its October 2007 peak. We're currently still down 39%. Believe it or not, Apple (NASDAQ:AAPL), Visa (NYSE:V), and Amazon.com (NASDAQ:AMZN) have rallied so much that they're closer to their all-time highs than this year's lows.
Still, a 55% drop is a lot. We've already surpassed the tech bubble and the oil crisis of the 1970s. Of course, even though it's not an entirely fair comparison, we have to consider the Great Depression to get a truly worst-case scenario. During the Great Depression, the stock market fell ... wait for it ... 89% from peak to trough!
Forget talk of Dow 5,000. As I've calculated before, that would be roughly Dow 1,500!
Don't panic yet, though. Let's move past the price movement and look at value.
Here's how much more
To assess how fairly valued the stock market is, Yale economist Robert Shiller keeps track of the market's 10-year P/E ratio all the way back to 1881. Averaging earnings over a 10-year period gives us a much smoother picture than a simple P/E ratio.
According to his calculations, the market's 10-year P/E stands at 15.5.
For comparison, the ratio hit an all-time high of 44 during the tech bubble (and has been declining ever since); it stood at 33 just prior to the Great Depression.
We're certainly a lot closer to the bottom than either of those times. Unfortunately, though, we've seen 10-year P/E's in the single digits many times before, and as recently as the early 1980s. A ratio of 15.5 doesn't sound bad, but it puts us at three times the all-time low of 5.
Although it still may be a great time to buy, stock prices could still fall quite a bit further.
But really, don't panic
So what can we take away from this? First, remember that I tried to be brutally realistic in drawing up downside scenarios. Envisioning the worst doesn't mean it'll actually come to pass. We could look back and see that March was indeed the bottom, or we could retroactively realize that this rally was merely as a dead cat bounce. Either way, we do know that we are working through some very real economic problems here.
It's helpful to get a feel for potential downsides, but trying to time the market is futile. Instead, take your time and look for stocks that are being punished unjustly -- the ones that will be here 10 years from now, but are selling like they won't be.
If you want help searching for treasure amid the rubble, I invite you to sign up for our Inside Value newsletter. You can see all the team's advice and recommendations for free with a 30-day trial, by clicking here. If you're not impressed, there's no obligation to subscribe.
Anand Chokkavelu owns shares of Apple and Citigroup. Apple and Amazon.com are Motley Fool Stock Advisor picks. The Fool has a disclosure policy.
