How low can stocks go? Updated risks and values – July 7th

How low can stocks go? Updated risks and values – July 7th

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: 11% from a record high
  • S&P 500: 6% from a record high
  • Nasdaq: within 1% of a record high

Another week, more momentum buying and where we stop no one really knows. Stocks were generally higher across the board over the past week, driven by momentum buying yesterday based on ongoing support from the Federal Reserve, the potential for another round of stimulus, optimism about a second consecutive month of better than expected jobs being recovered from the lockdowns and investors not really having other places to go with money. This despite the surge in COVID-19 cases which has led to a reversal of reopening measures spanning from California to South Florida. 

If it sounds like I don’t have a lot of confidence in the current rally – it's because I don’t exactly. Over the short-term irrational selling and buying can and does take place in the stock market. In the end it comes down to fundamentals. As stock prices rise, it’s not necessarily because fundamentals are improving. It’s because of a hope that they will. Higher prices simply create more short-term risk if there’s a disappointment. That’s where we are right now.

We are we right now?

Here’s where the markets stand year to date.

  • The Dow is down 7%, the S&P 500 is down 1% & the Nasdaq is up 11%

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: 22.36
  • S&P 500 avg. P\E: 15.79

The downside risk is 31% based on earnings multiples right now from current levels. This nearly equals the highest level of fundamental risk that’s been priced into stocks since the pandemic began. The last time we were near these valuations in early June, stocks sold off. While the markets, save the Nasdaq, aren’t at the same point levels as they were the fundamentals from earnings have deteriorated from a month ago. Stocks are about 6% lower in value on a fundamental basis than a year ago however fundamentals on trailing earnings will deteriorate. The market is priced as though earnings will only drop by about 6% this year without valuations becoming more expensive than a year ago prior to the pandemic. That makes me nervous over the short run. 

It's always important to ensure that you're positioned for negative adversity. If a 31% 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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