How low can stocks go? Updated risks and values – July 28th

How low can stocks go? Updated risks and values – July 28th

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: 10% from a record high
  • S&P 500: 5% from a record high
  • Nasdaq: 3% off of a record high

Stocks were mostly flat over the past week, though there was selling in technology specifically. This as earnings season was in full swing. On one hand 81% of companies which have reported so far have exceeded expectations. That’s helping support the market. On the other hand, earnings are 42% lower year over year for companies that have reported thus far. The combination of high stock prices and significantly lower earnings has led to a phenomenon that’s only played out four times previously in stock market history. A P/E or price to earnings ratio for the S&P exceeding 27 times earnings. That’s vastly higher than the average at around 16 times earnings. Yes, the feds are accommodating. Yes, lower interest rates make borrowing costs cheap for companies. No, there’s not a lot of value to be found currently in stocks.

If it sounds like I don’t have a lot of confidence in stocks at these prices currently – it's because I don’t. 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 flat & the Nasdaq is up 16%

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: 27.85
  • S&P 500 avg. P\E: 15.81

The downside risk is 43% based on earnings multiples right now from current levels. This equals the worst valuation for stocks since the recovery from the Great Recession over a decade ago. Stocks are 7% more expensive than a year ago at this time on fundamental basis and earnings are only set to worsen. This isn’t the best of storylines over the short-term and I’d be cautious about investing additional money at these levels that may be needed in the short run.

It's always important to ensure that you're positioned for negative adversity. If a 43% 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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