Is it time to buy? Part 3

Let's try to get a little more clarity on the earnings question. In our last post we noted that S&P operating earnings were still forecast at $97.32 for 2009, but almost sure to come down. The question is, how much?

Professor Robert Shiller (of "Irrational Exuberance" fame) has compiled some helpful statistics for us at http://www.econ.yale.edu/~shiller/data/ie_data.xls. What does his data show us?

It looks pretty scary. From 1917-1921, the S&P index's earnings fell from 29 to 4, a 90% drop. Let's hope that doesn't happen again.

What if we try something more familiar? In 1989, earnings were $45; in 1992, $26, a drop of 40%. More recently, from 2000-2002 earnings declined from $69 to $31, a 55% drop. By comparison, the 1974-1975 drop from $40 to $32, a decline of 20%, was downright mild.

How bad will it be this time? Profits were high for a prolonged time. Costs were kept low by cheap labor from China. And there's massive deleveraging that needs to happen throughout the economy. Sounds like this is more of a 40% drop scenario rather than a more benign one. I hope I'm wrong, but I'm afraid I'm right.

So, if we take 40% off of $97.32, we get $58.39. If we apply a P/E ratio of 12, which gives me a comfortable cushion versus the long-term P/E of 15 (though still well higher than the truly rock-bottom P/E range of 6), that gives me a price target of 700 on the S&P 500. Ouch!

Finally, a note on the rock-bottom P/E of 6. If we take out the Great Depression, the lowest P/Es of the early 1980s happened during the super-high interest rates brought on by Paul Volcker's fight against inflation. The math gets complicated, but basically, why hold stocks when bond interest rates are high? So I think we would only see a sustained P/E below 10 if long-term rates rise. How likely is this? Not that likely, I think - there's still a lot of liquidity in the world (if on the sidelines), though there are some serious imbalances ahead that will reduce available savings even as national expenditures rise - i.e. the retirement of the baby boomers. But as long as that doesn't cause an extreme rise in interest rates, P/Es shouldn't go super-low.

But even so, these calcluations make me nervous looking at today's S&P 500 of 966. We'll see. Like I said, I hope I'm wrong, but fear I'm right.