How Far Will The Market Fall?

As noted yesterday, generally speaking stocks today are showing all of the hallmark signs of topping out. The market is overpriced, overbought, the smart money is selling, CEOs are bearish, market breadth is shrinking and earnings growth looks poor.

Now, I am not officially calling a top in the market today. But I do want to alert you that a top of some kind, possibly major, is forming.

In terms of predicting how far the market will fall, we first need to consider that the stock market is in a bubble. Historically, bear markets feature a drop of 32%. Bursting bubbles on the other hand, usually feature a drop of 50%. Indeed, if you look at the last two market Crashes over the last 13 year, all of them featured drops of roughly 50% or so.

Based on this measurement, this would mean the S&P 500 falling to sub-900.

Other indications of a market top forming can be drawn from historical price movements. Mark Hulbert from Marketwatch recently noted that of 35 market tops since the 1920s, the preceding bull market has seen stocks rise 21% in the previous 12 months.

The S&P 500 just hit a 23% gain in the last 12 months (see Figure 5 below). So we’re on track with a market top in terms of historic price trends.

Finally, there are major valuation concerns for the markets today. Since the S&P 500’s founding in 1926, stocks have returned an average of 11% per year.

Consider the following: had you invested $10,000 in the S&P 500 in 1926 (at that time it was the S&P 90) with dividends reinvested today it would be worth over $33 million.

Without dividends reinvested, it would be worth $1.9 million. Put another way, without dividends, which are paid out of earnings, stocks return only slightly more than Treasuries, though with considerably more risk.

Thus, the ideal time to invest in stocks is a time in which future earnings yields from stocks are expected to grow considerably. This would indicate that dividends are likely to grow, thus allowing for a considering stock market “premium” in terms of returns.

Today is not such a time. As famed value investor John Hussman notes, the 10-year Treasury bond is currently yielding 2.6%. Hussman believes stocks will average 2.8% per year going forward for the next 10 years.

Thus, there is literally no “equity risk premium” at this time. Put another way, the benefits of owning stocks based on future earnings is simply NON-existent.