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If you believe an analysis I posted of a Fortune article last November, the answer is probably yes. This is based on a theory that stock prices needed to adjust downward for something called the equity risk premium.
How did Fortune arrive at the idea that the market needs an 18% drop? (I should note that Time Warner (NYSE: TWX) owns both BloggingStocks and Fortune.) Fortune 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 long way 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%. Or, if one assumes that stocks need to reach their 50 year equity risk premium of 5%, that's a 30% drop.
So how did I get to a 2,668 point drop? When I wrote that piece on November 28, the Dow was at 13,289 and it's now at 11,971, so it's only 10% corrected. To get to an 18% correction from that day, it would need to hit 10,896. In other words, to hit 18% it would have to go down about 1,000 points more. If you take the 30% correction, then it needs to drop another 2,668 points to 9,302.
The lower figure feels right to me. What do you think?
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 Time Warner securities.
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