How Low Can The Stock Markets Go?

How Low Can The Stock Markets Go? The Answer: Lower ... Much Lower.

By Nouriel Roubini (Doctor Doom) | 12 March 2009

For the last six months, I have been arguing that, in spite of the sharp fall in U.S. and global equities, there were significant downside risks to stock markets. Thus, repeated bear market rallies would fizzle out under the onslaught of worse than expected macro news, earnings news and financial markets/firms shocks— in the long run. [[Ah-h, but those short to intermediate term bear market rallies are likely to be pretty sharp— recovering 50% or more of previously lost ground. In the short to intermediate term, the market responds largely to its internal forces and to more general financial forces (eg, money flows); it is just not that tuned to economic conditions— unless they change radically.: normxxx]]

Put simply: If you take a macro approach, earnings per share of S&P 500 firms will be— quite realistically in 2009— in the $50 to $60 range. (Some may even argue that in a severe recession they could fall to $40). Then, the question is what the multiple, i.e., the price-to-earnings ratio, will be on such earnings. It is realistic to expect that the multiple may fall in the 10 to 12 range in a U-shaped recession.

Then, even in the best scenario (earnings at $60 and P/E at 12), the S&P index would be at 720. If either earnings are closer to $50 or the P/E ratio is lower, at 10, then the S&P could fall to 600 (12 times 50 or 10 times 60) or even to 500 (10 times 50). Equivalently, the Dow Jones industrial average (DJIA) would be at least as low as 7,000 and possibly as low as 6,000 or 5,000. And using a similar logic, I have argued that global equities— following the U.S.— had another 20% plus downside risk.

These predictions were made when the S&P 500 was close to 900 and the DIJA at 9,000. This basic macro approach was the reason why I've argued that the [EoY 2008] bear market sucker's rally— the one going from late November 2008 to early January 2009— would fizzle out, and new lows would be reached. And, indeed, like previous bear market rallies of the last year, this one too went bust— falling over 20%— with the DJIA and the S&P falling below the 7,000 and 700 upper limit of our range for U.S. equities. With the DJIA and the S&P now well below the "7" range, the next test for the markets may well be 6,000 and 600 for the two indexes. [[In the event, they continued on up from their March 6 lows of 6443 and 666 (the sign of the Beast!): normxxx]]

I have also argued that another bear market rally may occur some time in the second or third quarter of this year and may end up like the previous six. Indeed in the last 12 to 18 months, every time something dramatic happens (that leads to a lower stock market low) and the government reacts to it with a more aggressive policy action, optimists [quickly appear who] say that this is the dramatic and cathartic event that suggests a bottom has been reached.

They said that after Bear Stearns, after the collapse and rescue of Fannie Mae (nyse: FNM) and Freddie Mac (nyse: FRE), after Lehman Brothers, after AIG (nyse: AIG), after the TARP was announced, after the G-7 communiqué and after the $800 billion fiscal stimulus package was announced last November (the onset of the previous sucker's rally). And after a while, the markets are again "shocked, shocked" to discover that the macro news is much worse than expected in the U.S. and abroad; that earnings news is much worse than expected, not just for financials, realtors, home builders and consumer discretionary firms, but also for most other non-financial firms; and that financial markets/firms shocks are worse than expected.

This is what I see and argue: More financial institutions are effectively insolvent and will have to be taken over by the government; highly leveraged institutions— such as hedge funds— will be forced to de-leverage further and thus sell illiquid assets into illiquid markets; even non-levered investors (retail, mutual funds, etc.) that lost 50% plus on equities [[or other less than prudent ventures, such as ABBs: normxxx]] are burned out and want to reduce their exposure [to risk]; and a number of emerging-market economies are on the verge of a contagious financial crisis.

Why do even small, open economies such as emerging-market ones matter for global risk asset prices? Take the case of Iceland, a small island of 300,000 souls in the middle of the Atlantic: The local banks borrowed abroad 12 times the gross domestic product (GDP) of the country and invested it in toxic assets. Now the banks are bust, and the Icelandic government is bust as the banks are too big to be saved. Thus, local banks now selling distressed and illiquid assets into illiquid global markets are having ripple effects on those global markets.

So if tiny Iceland can have such a contagion effect, how much greater would the contagion be if a larger and more important emerging market were to enter a full fledged financial crisis (Latvia or Hungary or Ukraine or Pakistan or Venezuela)? Even a mere rating downgrade of Ukraine [recently] had a shocking effect on financial markets in Emerging Europe— and even in the E.U.

What are the downside, and upside, risks to the bearish predictions for U.S. and global equities? On the downside, I have argued here that there is at least a probability of an L-shaped global 'near-depression' rather than the mere current severe U-shaped recession. If a near-depression were to take hold globally, a 40% to 50% further fall from current levels in U.S. and global equities could not be ruled out. But in this L-shaped near-depression, the last thing one would have to worry about would be stock markets, as more severe issues would have to be addressed, such as unemployment rates in the mid-double digits— 15% or above— and multi-year stagnation and deflation.

On the upside, one could argue that the aggressive policy stimulus in the U.S. and some other countries will lead to a faster sustained economic and financial markets recovery than expected here. We have discussed why this "sustained" as opposed to "temporary in second— to third-quarter" recovery is highly unlikely to take place. But the bullish argument for a non-bear market and early persistent recovery of global equities is based on a better than expected recovery of the U.S. and global economy.

Earlier this year— at the peak of the [last] bear market rally— I met Abby Cohen— the ever-bullish equity markets expert at Goldman Sachs (nyse: GS) who predicted a 25% equity rally for 2008 and is again making a similarly bullish call for 2009. I asked her if we disagreed on earnings or on the multiple (P/E). It turns out that our forecasts for earning per share for S&P 500 firms are similar: in the 50 to 60 range for me and the 55 to 60 range for her. But she argued that a P/E in the 10 to 12 range was too low, as investors would ignore the bad earnings numbers for 2009. If a rapid recovery of earnings [could be anticipated] to occur in 2010 and beyond, investors would discount the 2009 bad [earnings] numbers and assign a much higher multiple of 17, or even more.

The trouble with that argument is that, with the U.S. and global economy in a massive slump, and with deflationary forces at work, it is hard to believe that a massive economic recovery will occur in 2010, thus lifting earnings sharply. Even in a U-shaped scenario, U.S. growth in 2010 would be 1% or lower, and Eurozone and Japanese growth would be close to 0%. With weak growth, deflationary pressure would still be lingering, putting pressure on profits, the pricing power of firms and, thus, profit margins. So even in a U-shaped scenario, a rapid rally of equities is highly unlikely.

It is true that equity prices are forward-looking: they usually tend to bottom out six to nine months before the end of a recession, as they 'see'— ahead of the curve— the light at the end of the tunnel. So the optimists seeing a recovery of growth in the second half of 2009 argue that equities should start to rally on a sustained basis now. But this severe U-shaped recession in the U.S. may not be over at the 24th month date (December 2009). Most likely, the unemployment rate will rise throughout 2010 well above 10%, and the growth rate will be so weak (1% or closer to 0%) that we will remain in a 'technical' recession for most of 2010 (36 months if the recession is over only by December 2010). Thus, the bottom of the stock market may occur in late 2009, at the earliest, or possibly some time in 2010.

Also the "six to nine months ahead forward-looking stock market view" is not always borne out in the data. During the last recession, the economy bottomed out in November 2001 and GDP growth was robust in 2002, but the U.S. stock markets kept on falling all the way through the first quarter of 2003. So not only were the stock markets not "forward looking," they actually lagged the economic recovery by 18 months— rather than leading it by six to nine months.

A similar scenario could occur this time around. The real economy sort of exits the recession some time in 2010, but deflationary forces keep a lid on the pricing power of corporations and their profit margins, and growth is so weak and anemic, that U.S. equities may— as in 2002— move sideways for most of 2010. A number of false bull starts would occur as economic recovery signals remain mixed.

Thus, most likely, we can brace ourselves for new lows on U.S. and global equities in the next 12 to 18 months. Eventually, a more sustained recovery will occur once we are closer to clear signals that this ugly global U-shaped recession is not turning into an L-shaped near-depression, and that the global economic recovery is clear and sustained. Until then, expect very volatile and choppy U.S. and global equity markets— with new lows reached in the next months and the year ahead.

Nouriel Roubini, a professor at the Stern Business School at New York University and chairman of Roubini Global Economics, is a weekly columnist for Forbes.com.

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Normxxx    
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