How Low Can It Go? Possibilities from Dispassionate Market Valuation Models

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Recently a friend sent me an email asking, “How far does the stock market have to fall until you would say it is in neutral territory – that is, neither overpriced nor underpriced?”

The market is displaying wild day to day swings and is exhibiting classic emotional behavior. To attempt to get a handle on market value based on rationally-derived metrics, I applied an old respected tool, the Gordon Model. The model generated a wide range of outcomes for S&P 500 Index 12 month returns. They ranged from 26% to -44%, with a plausible scenario drop of 24%.

A CAPE partial mean reversion scenario suggests a possible 18% decline, while a worst case scenario shows a whopping 48% decline. These extremes contrast a “back of the napkin” view that P/E ratios are low. A return to recent levels could generate a gain of 13% in 12 months.

Wise investors will avoid market timing, rebalance and dollar cost average into attractive sectors. But it might be wise not to rush in right away given that risks appear skewed to the downside.

See the full article on SeekingAlpha.