Thursday, October 9, 2008

How low can it go? A back of an envelope calculation...

With the market pushing 9000 mark from above, I was wondering how low is really low? Is it 9000? 8000? 4000? So here's my estimate.

The market price has two components - earnings, and P/E (price to earnings) multiple. The former reflect the factual state of affairs, the later - consisting of the bizzare goo of expectations, punditry, "animal spirits of the entrepreneurs", and the like - the phychological state of the investors.

P = (P/E) * E

Here's the P/E chart for the last 100+ years:

The recent P/E ratio was hovering around 25 - way below the absolute maximum of the .COM boom, and still below the short period right before the great depression, and yet much higher than during the rest of the modern history. Just looking at the graph, it looks like it's reasonable to expect that during an economic downturn the P/E ratio could return to a more typical 10-15 range.

Let's say it's 12.

Now what about earnings? A big difference in consumption that I observed while traveling outside the US was this: in the US, stores are full of cheap stuff, and people buy it profusely. For example, the average number of TV sets per US household: 2.24. The average size of household: 2.5. By comparison, prices for consumer goods in Europe are much higher (or at least were much higher until dollar tanked), and the salaries are lower. So people buy less.

In a slow economy, can a US citizen get by with fewer than 3 TVs? 2 cars? a smaller house? You bet! I can easily see consumer spending dropping by 30% just to eliminate the senseless, excess consumption that does not really improve the quality of life.

Of course a 30% less in consumer spending will probably result in similar drop in business investment, etc. But let's say that overall effect on the economy is a 20% drop in profits, just to be safe.

What we get with this numbers is

(Future Dow) = (Recent Dow) * (Future P/E) * (Future E) / ((Recent P/E) * (Recent E)) = 14000 * 12 * 0.8 / 25 = 5000.

Which is to say - it's NOT UNREASONABLE to expect that Dow can go down to 5000 - not that I KNOW that it will really happen. :-).