Regarding Valuation. What Could Go Wrong?

A synopsis of questions from yesterday. Regarding equity valuation who says stocks can't trade lower? Have they ever traded lower historically?

First there is no law that says stocks can't go lower. I repeat. There is no law that says stock prices cannot go lower.

They most certainly will decline if the recession is deeper than most of us think right now. There is also nothing that says that stocks have to trade at multiples close to their historic standards-perhaps we will be in an era that owing to the higher levels of volatility stocks multiples will contract. Our numbers are our baseline scenario that we review all the time and change when needed.

You want a nightmare scenario here it is: Earnings collapse and S&P 500 earnings don't trough out until sometime in 2010. The economy enters a low to no growth era. Unemployment remains stubbornly high. Throw in an unexpected political crisis, a foreign policy crisis or an unforeseen natural disaster-seems we haven't had a Katrina or an earthquake recently. Then look out! The S&P could in that instance trade down to its historic trough multiples which would likely equate to S&P 500 stocks at some point trading down to between 600-700. That is the potential for stocks to fall another 35% from here. Stocks have seen valuation levels that low before in both 1974 and in 1982. One difference though was back then government bonds yielded substantially more than they do now and inflation was a significant problem. In 1974 bonds yielded 8.4% and in 1982 they yielded 14.6% on the 10 year. Today that less than 4% yield ought to give us some floor higher than where we are now. Again I don't think this is the likely scenario but it is out there and it is one we can't completely dismiss, particularly as we draw up the game plan for 2009.