Fortune -- which like BloggingStocks is owned by Time Warner (NYSE: TWX) -- believes that the stock market needs to fall another 18% in order to put equity investment risk and return back in balance. Thanks to what it calls the equity risk premium -- the amount of additional return over risk-free treasury bills that an investor needs to justify buying riskier stocks -- the market has further to fall.
How did Fortune arrive at the 18% drop? It calculates the current equity risk premium by adding stocks' earnings yield which it gets by flipping the market's P/E on its head (calculating E/P) to the inflation rate and then subtracts the t-bill yield. Then it compares the current value with the long run equity risk premium to conclude that stocks have a ways to fall before their prices align with that long-run value.
Here are the numbers. The market currently trades at a PE of 16 -- but based on adjustments to remove short term spikes by Yale market guru Robert Schiller -- Fortune uses a PE of 22 -- which is the inverse of the market's earnings yield of 4.5%. Investors expect equity returns of 7% -- calculated by adding expected inflation of 2.5% to that 4.5%. To get the equity risk premium of 3% Fortune subtracted the 10-year treasury rate of 4% from that 7% expected return. Got that?
But we're not there yet. Over the past 50 years, the risk premium has averaged around 5%. Given the ease of diversifying portfolios and the Fed's ability to smooth economic cycles, investors only need 4%. To get from the current equity risk premium of 3% to long run level of 4%, Fortune calculates that stocks still need to drop an additional 18%.
Technology stocks like Google Inc. (NASDAQ: GOOG) are likely to take a hit. Google's P/E now stands at 52 -- so an investor expecting a 10% annual return would need Google's market capitalization to double to more than $400 billion by 2014. Even if Google kept a P/E of 30, it would need to earn $13 billion by then. Today, it earns about $4 billion. So its profits would need to more than quadruple in seven years. That seems like quite a stretch to me.
What do to about this 18% market tumble? You could sell now and wait for the market to fall and then buy back in when it hits bottom. Unfortunately, nobody rings a bell for you when that happens. Or you could just prepare for a rocky ride and hold onto your stocks for the long run.
Update: How did Fortune arrive at the 18% decline? To get the equity risk premium from 3% to 4%, the E/P has to rise from 4.5 to 5.5. This is equivalent to a P/E decline from 22 to 18, which is 18% (22-18)/22. If Fortune had assumed that stocks would converge on their 50 year equity risk premium of 5%, the E/P would need to rise to 6.5 -- the P/E equivalent would drop from 22 to 15.4 -- representing a 30% decline.
Peter Cohan is President of Peter S. Cohan & Associates. He also teaches management at Babson College and edits The Cohan Letter. He has no financial interest in Google or Time Warner securities.
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Reader Comments (Page 1 of 1)
11-28-2007 @ 10:38AM
JR said...
There must be a financial wizard with some knowledge of writing software who could come up with a computer model that would show the affects on the economy when oil goes up, or taxes are lowered during wartime, job losses or increases, major changes to the tax code, Condi Rice buys 6 dozen more new shoes, Cheney plugs another politician, imports vs. exports, etc.
12-02-2007 @ 5:56PM
Sam said...
I think your focus on GOOG is misplaced--given earnings of $3B in 2006, reaching $13B in 2014 is just earnings growth of 20% annually. They're at roughly 50% growth now--they can slow quite a bit over 8 years and still get there.
12-03-2007 @ 2:55AM
EF said...
It's easy for Google to make $13b by 2014: just print more money! The Fed seems to be on point; same with our government.
Now, it is, of course, very likely that PE ratios are going to drop, but what can you do? It's not like you are going to do better holding a bunch of dollar bills...
Can you suggest some better alternatives to investing in stocks like Google?