Filed 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?

Continue reading Why the market will drop another 18% and how Google will feel the burn

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This entry was posted on Wednesday, November 28th, 2007 at 3:37 pm and is filed under Stocks Money News. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.