Will the Stock Market Plunge Continue?

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I usually ignore stories trying to predict stock market drops. Who really knows? Not me. But with stocks down more than 250 points today, Fortune’s article earlier this week by veteran writer Shawn Tully is looking very prescient:

Here’s how I see the odds. The chances are about one in three that we suffer a huge, wrenching correction in the next year or two similar to the one in 1987. That possibility is so high because stocks are so startlingly expensive. Another high probability event is that markets go on a long sideways grind, with smaller drops along the way. What’s extremely unlikely is that the market rises substantially from current levels and stays there for any extended period.

OK. I wouldn’t call today a crash, but there is a lot in Tully’s article that makes a lot of sense. And I think it does a lot better job than some other arguments against the stock market. Here’s why:

There has been a growing sentiment on blogs against stocks. It started with a video from excellent blogger Felix Salmon:

Naturally, the video being less than 80 seconds long, there wasn’t room for a lot of background and exegesis. But the message I was trying to send is not that I think stocks are going to fall. Rather, it’s that volatility has risen, and that it makes sense to sell stocks in periods of high volatility.

Salmon probably wishes now he said stocks were going to fall. But nonetheless, Salmon set the ground work for an important argument about stocks. For stocks to be attractive they not only have to be priced well to earnings, but also the risk of owning stocks. Here’s where Tully picks up relating Salmon’s general analysis of stocks to today’s valuations and earnings forecasts:

Today, the [dividend] yield [of stocks] is 1.8%. Earnings per share typically grow at a “real” rate of around 1.5%, way below the pace that Wall Street advertises. So the total gain from investing at today’s prices is 3.3% or so, plus around 2.5% for inflation, for a total of between 5.5% and 6%.

That’s not enough. Stocks are far too risky for investors to accept those puny rewards, as the wild swings of the last two years, and last two weeks, make abundantly obvious. The only way for future returns to rise is for PEs to fall.

How far must prices fall to get back to basics? For the S&P to return to a PE of around 14, the index would need to drop by around 33% to less than 800, its range in early 2009. That would substantially raise dividend yields, and raise future real returns into the high single digits, where they belong.

The compelling case for me here against stocks is this: Tully and Salmon are not just spinning a story on how the Greek crisis or anything else will bring down the US economy and stocks. Those types of arguments are less believable to me because I’m not sure how anyone can know how those things will affect stocks. What’s more, by the time you spin those scenarios it usually is priced into stocks. So yes, there might be some selling on fear today. But what Tully is pointing out is a much more serious long-term problem for the market.