From Bloomberg:

Stocks slid worldwide, sending the Dow Jones Industrial Average below 7,000 for the first time since 1997, and Treasuries rose after Warren Buffett said the economy is in “shambles” and American International Group Inc. posted the largest corporate loss in U.S. history….

The Dow average decreased 256.15 points, or 3.6 percent, to 6,806.78 at 3:11 p.m. in New York. The Standard & Poor’s 500 Index dropped 4.2 percent to 704.47. Europe’s Dow Jones Stoxx 600 Index tumbled 5 percent, its steepest loss of the year. Fourteen stocks fell for each that gained on the New York Stock Exchange, making it the broadest decline in two weeks.

Treasuries rose as investors sought a haven, driving the yield on 10-year notes down to 2.9 percent from 3.01 percent.

Which brings up the question: How low will the equity markets go? Or better yet, how low should stock prices be?

One of the simpler and clearer ways to value a stock is by looking at the Price to Earning ratio (P/E):

When it comes to valuing stocks, the price-to-earnings (P/E) ratio is one of the oldest and most frequently used metrics. It is calculated by taking a company’s share price and dividing this by its earnings per share. This provides a measure of the price being paid for the earnings – the higher the P/E, the more expensive the earnings. However, a company’s standalone P/E doesn’t give us a full picture of how expensive a stock is unless we look at it relative to the company’s industry or a broad market index such as the S&P 500 and the Dow Jones Industrial Average (DJIA)….

The P/E of an index – the total price of the index divided by its total earnings – is a little more difficult to come upon. Many financial websites have P/Es for individual companies, but not for indexes like the DJIA or S&P 500. To get this information, you have to go straight to the source – the index’s publishers. For example, you can find the P/E for the S&P 500 on the Standard & Poor’s website and for the DJIA on the Dow Jones website.

Another way to get an estimate of the P/E ratio is to look at the P/E ratio of an exchange-traded fund (ETF), which closely follows the index in question. While this measure is not as exact as the index’s own measure, the information is a lot easier to find. For example, the P/E for the Wilshire 5000 can be obtained through VIPERS or the Nasdaq 100. This will work with the DJIA and the S&P 500 as well.

Got it? The higher the P/E ratio (relative to the stock in other companies, or relative to history), the more a stock is overvalued.

Let’s look at the S&P 500’s P/E ratio (found by slog commenter F):
6792/1236033652-sp500_pe.png (Most recent data to the left. Dark blue line is the mean for this time period.)

The P/E ratio of the S&P 500 stock index today is still in between the high and low points of our recent history. Given that earnings are continuing to drop, stock prices should fall even more to hit the historic average P/E ratio, let alone a bottom.

I’m just deliriously happy Social Security wasn’t invested in the equity markets just before the crash.

(Updated with numerous corrections, mostly because I foolishly used a bad source of data for the S&P 500 P/E.)

Jonathan Golob is an actual doctor.

27 replies on “How Low Will It Go?”

  2. Using metrics such as P/E is the root of “Value Investing” – a philosophy who’s most famous proponent is Warren Buffet.

    It offers a means to attach an actual value to a share of stock. For example – a company with a low P/E could offer a higher dividend to shareholders. That dividend would the represent the “return” on that share of stock.

    It is diametrically opposed to the speculative investing with the specious and fabricated “lines of resistance / support” and rumor-driven manipulations of the likes of Jim Kramer.

  5. You’ve got your P/E stats all wrong. In bubble times it goes as high as 30 or 40. In crashes it falls to 10 or lower. Average is around 12-16. I have no idea where these big numbers would come from. I love you Golob, but this is as if you said gravity was a velocity of 100 m/s. Stick to science.

    BTW, the reciprocal (E/P) is a percentage. So in crude terms a p/e of 20 means the market returns 5%, 10 means 10%, etc.

  7. Jonathan, are companies with negative P/E ratios excluded from the average? With companies taking losses, it’s a bit harder to gauge what the P/E means. For example, a company that breaks even has 0 earnings, and a P/E ratio of infinity. A negative ratio is equally meaningless.

  8. c m: I’m using the SPY ETF’s price as a surrogate for the true S&P 500 P/E. Hence the funny numbers.

    It was the data I could link to, for free, from Slog. I’d love to get the real S&P 500 numbers.

  9. It’s around the mid-point.

    Dow 6000.

    But for anyone not 60, this is great, cause you can dollar cost average into stocks right now, with a low-cost index fund, and buy them around their actual worth, not the inflated price under Comrade Bush.

  11. Um, Jonathan, you kinda screwed the pooch on this one. The SPY is an ETF meant to track the S&P 500, not it’s P/E ratio. If you had looked closely, you might have noticed that the SPY values are almost exactly 1/10 those of the S&P 500. So the SPY provides you with the P, but not the E.

    c m gets it right with the normal values. The current P/E ratio depends on where you get your E from. If you use operating earnings, which are meant to exclude unusual charges, the P/E ratio is now at 12.8, down from a high of 30. If you use reported earnings, the P/E ratio is now 26, down from a high of 46. And if you use earnings averaged over the last 10 years, the P/E ratio is now 12.3, down from a high of 43.

  12. Come on, Jonathan! This is embarrassingly wrong. This is a graph of the SPY price, which is _not_ a surrogate for the S&P 500 P/E; it’s just linked to the S&P’s actual value. The actual current P/E is on the page you linked, and it’s slightly over 10 – which is actually quite reasonable, by historical standards.

  17. It should be noted, BTW, that the current P/E ratio may be misleading; it may be that many prominent S&P companies are poised to announce much lower earnings this quarter that will bring it up. However, the economy’s been craptastic for long enough now that there may not be as many big surprises left.

  19. @9

    You’re right, Will.

    This is SO FUCKIN’ GREAT !!!

    Since Comrade Pelosi became Speaker we have lost
    MORE THAN HALF
    of the value of our stock holdings !!!

    I can’t get over
    HOW FUCKIN’ GREAT THIS IS !!!!!!!

    You really should get your own show on CNBC.

  21. 20
    I want to clarify:
    Jonathan is not a stupid etc etc.
    And Slog needs at least one who is not.
    And Jonathan is that (only) one.
    who is not

  22. @19 – look, are you 60?

    If not, then thank your lucky stars the crash didn’t happen right before you retired.

    P/E above 15 – means don’t drink the kool-aid.

    P/E below 7 – FSM’s in His/Her/Its Heaven.

  23. I’m with @17. I think you’ll find that PE’s are closer to 12-14 once you factor in the lower earnings we have been seeing, and will continue to see. The first time we see a batch of (even mildly) positive earnings, you’ll see prices start to rise again. That said, we wound up down 4+% today. Daaaamn.

  24. What is the book value of a share of the SP 500?
    $560- $590 ??? If so, we aren’t far off. And I heard today that money markets are currently holding 50% of the money now invested in equities. That is one helluva lot of money sitting on the sidelines.

  25. I should point out part of the problem with using any index is that stocks fall in and out of the basket, and the S&P 500 is only an indicator, in that some stocks are dropped and some added periodically.

    So measuring a basket of fruits and vegetables over time where the mix is adjusted as some fall out of favor and are then replaced by more current ones is a better way of looking at it.

    If you haven’t put money in your 401(k), 403(b), or Roth IRA, start doing so. Buying on the downslope may feel like catching a falling knife, but once the inflection point is reached it’s more like snowboarding after the cliff mellows out.

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