Good morning. Fortune Senior Correspondent Shawn Tully here.
Public company CFOs live by their stock prices—and die by them too. So it’s no surprise that plenty of finance chiefs are watching the markets with bated breath these days. After all, in just 18 trading days in September the S&P 500 has dropped some 5.3%.
But I believe the worst is still to come.
As I recently wrote in Fortune, an analysis of stock market valuations compared to historical norms using Robert Shiller’s famed CAPE metric suggests we’re looking at a market that has a lot further to fall. As I wrote:
The real 10-year rate equals the yield on 10-year TIPS, or treasury inflation protected securities. The recent jump in the long bond has driven the TIPS rate to 2.37%, the highest number in 20 years, excluding a brief explosion in the Great Financial Crisis. TIPS offers folks and funds a return of 2.37% points over projected inflation, on totally safe bonds. That’s a lot of competition for stocks, which are anything but safe, and seldom riskier than right now.
Of course, investors demand a premium over the risk-free real rate to choose equities, given their careening course, over the safety of Treasuries. Typically, that spread—known as the equity risk premium, or ERP—averages around 3.5 points. So the best estimate of the return investors expect from stocks going forward is 5.9%, which is the 3.5% ERP plus the real yield of 2.37%, plus inflation.
To get a 5.9% real return, a basket of stocks must pay you $5.90 for every $100 you invest. That’s a P/E of roughly 17, which, by the way, is around the S&P average over the past 150 years, though it’s been much higher in past decade of Fed-engineered super-low rates.
A multiple of 17 times our “normalized” earnings estimate of $160 gives an S&P of 2,720. That’s 43% lower than the level on September 26.
To be sure, a 40% drop may not be in our future. But a big decline is certainly feasible, because that’s what the hard math implies.
You can read the full analysis here.
Shawn Tully
shawn.tully@fortune.com
