Opinion

How deep is the investment canyon?

On a recent trip to Singapore, my wife and I took a cable car ride between two islands.

On a recent trip to Singapore, my wife and I took a cable car ride between two islands. The effect, sitting in an open car hundreds of feet above the harbor, rocking in the wind, was as unsettling as you can imagine.

Both of us took turns looking down over the edge, and when we got to the end, we looked back and thought about what could have happened to us.

That experience comes back to me vividly as I think about the market collapse and the partial recovery we have just witnessed. Most of us have muddled through, but it has been very scary, and unlike my cable car ride, there is no station on the other side to focus on to reassure us that an end is near.

And, unlike a cable car, we can’t just walk away from the markets once our feet are safely on land. We have to get on the next stretch of cable and commence a journey over a canyon of unknown depth and width.

With that in mind, I thought it would be useful to look at just how deep and wide that canyon could be. The last market drop came as a shock to many of us: We didn’t know it could be that bad, and we were unprepared for what happened.

While we hope the worst is behind us, as we move forward, let’s consider just how bad it could get, so we won’t be as surprised again.

Since last fall, we have been hearing, “Not since the Great Depression …” at the start of many sentences. In fact, by almost all metrics, this has been the worst U.S. economic crisis since the 1930s. We have blown through all previous comparisons except the big one. So what would it mean if it were to get as bad now as it was then?

The worst-case result is based on percentage declines from the top. If the decline were to match that of the Depression, the Dow Jones industrial average would be around 2,000; the Standard & Poor’s 500 stock index would be around 200.

Could this happen? It is not probable. Indexes at these levels would show a price-earnings ratio of 3.4, which is less than half the levels we saw during the Depression and lower than it has ever been.

Such levels don’t consider the current interest rate and inflation environment, and they completely ignore governmental actions. So, more realistically, can we estimate a downside limit?

One way to do so is to look at the current interest rates and add a risk premium to estimate the earnings return required for stocks in previous bottoms. Reversed, this gives us a P/E ratio. This can then be combined with earnings — I use 10-year averages — to give us a reasonable bottom-line value.

The risk premiums have generally topped out around 5%, but in the Depression they topped out around 10%. The 10% premium and current interest rates suggests a floor value for the Dow of around 4,000 and around 400 for the S&P 500.

These figures are reasonably consistent with the long-term patterns displayed by the indexes. There is also a very interesting chart of the inflation-adjusted path of the Dow, which suggests that the bottom should be around 4,000. This is available at chartoftheday.com, Sample No. 3.

None of this is, of course, predictive, but the conjunction of several indicators suggests that the conclusion is at least plausible. It also suggests that we may not have seen the end of this decline. If we are in a Depression scenario, the recovery will be slow, and there will be plenty of time to retest the lows.

One final point: I mentioned that we should look to the past in an effort to better prepare for the future. History suggests that values can go much lower than we have seen recently. We need to acknowledge that potential scenario and prepare our clients for it. History also suggests that there is a good probability the recovery will be difficult. I recommend a paper, “The Aftermath of Financial Crises,” by Carmen Reinhart, professor of public policy and economics at the University of Maryland in College Park, and Kenneth Rogoff, professor of economics at Harvard University in Cambridge, Mass. It can be found easily on Google, and it is an accessible piece that provides valuable context for the next several years.

So, as we step into our cable cars — along with a group of very nervous clients — we should have some idea of how bumpy the ride can get, not to mention how to better prepare for that eventuality.

Brad McMillan is the vice president and chief investment officer at Commonwealth Financial Network in Waltham, Mass. He can be reached at [email protected].

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