Is there a possibility -- a serious possibility -- that the Dow will go down to 10,000? Even lower?
Yes, the U.S. Federal Reserve has intervened and cut the discount rate by half a percent. Not to mention the EU central bank pumping hundreds of billions in one week to prop up the tottering world stock market. So stocks jumped 200 plus points for that day. Is the worst over?
Not by a long shot.
Here’s one good reason. The stock market is dangerously overvalued.
Wall Street soothsayers (erh, ”analysts”) claim the stocks in Standard & Poor’s 500-stock index have a price-to-earnings ratio (P/E Ratio) of 16.5. If that’s so, that’s quite normal, they reassure us, pointing out that the P/E ratio since World War II has been 16.1.
Therefore don’t worry, be happy!
But what most people don’t realize is that it’s another of Wall Street’s funny calculations. In the tradition of Voodoo Economics.
The problem with this P/E ratio? It’s cooked. It’s based on one year’s worth of earnings.
FACT CHECK: Columbia University professors Benjamin Graham and David L. Dodd, in their classic book on investment theory ”Security Analysis,” (the bible for the likes of Warren Buffett) stressed that the P/E ratio should be calculated on the basis of profits for ”not less than five years, preferably seven or ten years.”
Using the Graham-Dodd formula, based on average profits over the past ten years (including the Internet bubble heyday), the P/E ratio of Standard & Poor’s 500-stock index comes out to a very, very inflated 27!
As the New York Times pointed out on August 15 in its ”Remembering a Classic Investing Theory” article, a 27 P/E ratio is ”higher than it has been at any other point over the last 130 years, save the great bubbles of the 1920s and the 1990s.”
”In fact,” the Times concludes, ”the stock run-up of the 1990s was so big---that the market may still not have fully worked it off.”
What’s worse is when the IT bubble was bursting, Alan Greenspan and the Bush regime cooked up a very effective replacement: the real-estate bubble of the past few years, now in its death throes.
Anyone who has read New York Times columnist and MIT/Princeton Economics professor Paul Krugman or has listened to Morgan Stanley’s Chief Economist Stephen Roach, is familiar with this.
Since the correction of the IT bubble was aborted, and that bursting bubble was replaced with the real-estate bubble, there is a hell of a lot of market ”correction” to be done.
And the subprime mortage market’s collapse, the ominous hedge fund troubles, and the recent panic requiring central banks in U.S. and Europé to pump in hundreds of billions to prop up the tumbling house of cards --- well, all that tell us the much-delayed "correction" is on its way. And it will most likely be ugly and nasty.
Running out of new tricks, Wall Street has been lamely trying to replace the quickly-deflating real-estate bubble with a revived Internet bubble. Think deals like YouTube, MySpace, etc and the hyperventilating press over them. But the past two weeks say it’s not working.
Contrary to all of Wall Street’s cheerleaders and hucksters, and despite momentary rallies, there is a serious possibility that the Dow will keep sliding--- to as low as 10,000. Possibly lower.
The chickens are coming home to roost.