Why the market will drop another 18% and how Google will feel the burn
Posted by: in Goog newsFiled under: Google (GOOG), Time Warner (TWX), Economic data, DJIA
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.
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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