How low can stocks go? Updated risks and values – May 12th

How low can stocks go? Updated risks and values – May 12th

Bottom Line: The purpose of this story is to inform you as to what's possible in a near worst-case outcome for the financial markets. The reason is to understand what's possible, though unlikely, so you can plan soundly for your financial future unemotionally. The US stock market is the greatest wealth creation machine in the history of the world. I want you to benefit from it without making emotional mistakes with money.                  

Too often when we have a rare short-term downturn in the markets - it's too late to offer up information that might have been helpful ahead of time. This week's edition of "how low can stocks go" goes as the Dow, S&P 500 & Nasdaq stand against their all-time high levels:                           

  • DOW: 18% off record high
  • S&P 500: 14% off record high
  • Nasdaq: 7% off record high

Optimism has generally reigned supreme. In fact, technology is so hot the Nasdaq has turned positive for the year and is out of even correction territory from all-time highs. That’s pulled stocks higher across the board as we’re continuing to see states reopen, 41 and counting, along with positive trends with new cases across the country. It’s been key that the states which opened soonest have generally been able to reduce new cases while continuing to reopen businesses. While it may not be reported on by news media in general, it’s certainly not lost on investors. Couple that with the trillions of dollars pumped into the financial markets and voila – you have the makings of a market that performs better than the real economy at large. It’s a different version of a similar thing to what happened with QE during the Great Recession. 

The recent performance in the financial markets is the latest reminder to not let your money and emotions cross paths. Selling at the lows in March would have left you missing out on returns of around 30% over the past six weeks. The question now is...where do we go from here? We have the highest unemployment rate since the Great Depression and even states that are reopen are only in phase one. The better news comes over the next couple of weeks if phase one goes well. Two weeks of sustained progress allows for phase two reopening. And two positive weeks from there allows phase three. That’s a lot of what ifs, and it also requires politicians to trust the process and place facts and freedom ahead of fear and control.  

Earnings season has panned out a bit better than anticipated, but mostly, the belief is that the worst in the pandemic is behind us and the economy will begin to improve from here. If we hit stumbling blocks during the reopening process and/or if the economic damage is worse than currently anticipated – there's a fair amount of downside risk in the markets. Earnings follow-through will need to happen down the road. 

Here’s where the markets stand year to date.

  • The Dow is down 15%, the S&P 500 down 9% & the Nasdaq is up 2%

If only market fundamentals mattered here's what we'd want to consider regarding the S&P 500 for example.                           

  • S&P 500 P\E: 21.01
  • S&P 500 avg. P\E: 15.78

The downside risk is 25% based on earnings multiples right now from current levels. That's 8% less risk compared with this time last year, however fundamentals on trailing earnings will deteriorate. The market is priced as though earnings will only drop by about 8% this year. That might be a bit too optimistic. I’d prepare for the additional 25% drop at this point with a further reevaluation as earnings begin to roll in – just in case.

It's always important to ensure that you're positioned for negative adversity. If another 25% decline wouldn't affect your day-to-day life, you're likely well positioned. If not, you should probably seek professional assistance in crafting your plan that balances your short-term needs with long term objectives.

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