Have US equities fallen enough?

Stock gains from the last decade have already been lost. That sounds scary and pessimistic. Here are some stats from the WSJ:

The Standard & Poor's 500-stock index, the basis for about half of the $1 trillion invested in U.S. index funds, finished at 1352.99 on Tuesday, below the 1362.80 it hit in April 1999. When dividends and inflation are factored into returns, the S&P 500 has risen an average of just 1.3% a year over the past 10 years, well below the historical norm, according to Morningstar Inc. For the past nine years, it has fallen 0.37% a year, and for the past eight, it is off 1.4% a year. In light of the current wobbly market, some economists and market analysts worry that the era of disappointing returns may not be over.

This is an awful return compared to the US long term trend of 3% real GDP growth.

Here is a comparison with conservative US Treasurys:

Big U.S. stocks were outrun even by Treasury bonds, which historically perform much less well than stocks. Adjusted for inflation, Treasurys are up 4.7% a year over the past nine years, and up 5.8% a year since the March 2000 stock peak. An index of commodities has shown about twice the annual gains of bonds, as have real-estate investment trusts.

In my opinion, the bull run in stocks from 2003 to 2007 was primarily fueled by two factors - consumer spending due to increases in home equity from rising house prices leading to a refinancing boom and significant corporate investment, both of which were the result of low interest rates. Here I would like to argue that had the unusual rise in home equity been absent, US GDP growth would have been much lower. It seems to me that the recent bull market was shaky primarily because the GDP growth wasn't exactly on sound basis. Unsustainable rise in home prices caused an illusion of growth.

Some investors and economists believe that soon the whole credit crisis will be behind us and the US economy will be back on track of 4% real GDP growth. I disagree with this opinion and the reason is that during this bull market wages have not risen enough to sustain consumer spending. Now that housing prices are retreating, how does anyone expect to sustain the same level of consumer spending. This will probably result in a prolonged recession, which might not be as deep as in the past but certainly not as short as the recent bear markets have been.

According to Robert Shiller from the same WSJ story:

... the S&P 500 traded in the late 1990s at more than 40 times its component companies' profits -- far above the historical norm of 16. (To avoid distortions, he uses average profits over a 10-year period.) Today, the S&P 500 still trades at more than 20 times profits -- still far above average.

Additionally I believe that analyst estimates of S&P500 earnings are still on the higher side and there are going to be a downward revisions. This will make P/E even higher if the stocks remain at the current level. To get to P/E of 14 or 15, stocks have to come down further and my crude estimate suggests that S&P500 index might come below 1100 before we will see a bottom of this bear market. As painful as it seems, it might turn out to be a reality.

A number of investors argue that since global economy is in good shape with emerging markets booming forward with their high growth rates, US stocks are becoming undervalued. I disagree with this argument too because a significant portion of the growth in emerging markets comes from exports of which US and Europe are main consumers. If US and European consumption slows, isn't that going to affect these economies? How much would that effect be? At this point, I don't think I have the answer and the stats or the skills to determine that. May be my friends in the blogosphere can shed some light on it.

But all is not doom and gloom in the US equities. There are some factors that have potential of putting a bottom under this bear market. First, the world is flushed with petrodollars, and they are looking for a home. We have seen sovereign wealth funds from the East investing in Citibank and Merrill Lynch. I think many more deals will happen. Second, a lot of investor money that came out of real estate and other investments can flow into US equities. Although right now it seems that its favorite destination is in the commodities. Third, the recession can convince people to save more and some of that savings can flow into funds which in turn direct them to equities.

Bottomline is that I don't see a bottom in US equities right now but by the end of this year or the first half of next year, we might get there. But this downward journey will certainly be painful.