Monday, March 2, 2009

Calling a bottom?

CrossingWallstreet explains why "Trying to pick the bottom, however, is a dangerous undertaking and is, in his opinion, best left alone".

With the market making new lows Prof James Hamilton has an excellent post on stock prices and fundamentals trying to answer the question: "How low can stock prices go, and how worried should you be?"

He uses a Dividend Discount Model under two scenarios (1) real dividend grow 2% from the last reported value (2) dividends first follow the same path as during the great depression and then grow again.

Figure 4.Black line: actual stock price. Blue line: perfect-foresight price P*(t) under scenario 1. Green line: perfect-foresight price under scenario 2 (Great Depression II with dividends taking the same path as between 1931 and 1936)
According to Prof Hamilton at 608 the S&P500 would price in the same dividend trajectory as during the great depression and 5.5% real annual returns forever.

At a level of 735 and assuming the market drops to 608 before recovering the market is pricing in 3.6% real return over 10 years. Not bad.

His conclusion: "Of course, under this scenario you would do better waiting for the market to recognize the depression and wait to buy at 608 rather than now at 735. Moreover, given the historical tendency for over exuberance in upswings and excessive pessimism in downturns, you might expect the actual price to fall well below 600 in another depression, at which point there will be returns to be had well in excess of 5.5% if you time your moves just so.

But good luck with carrying out that particular scheme. After all, scenario 2 assumed we're about to start another Great Depression, and hopefully it goes without saying that this need not necessarily happen. If it doesn't, you may find yourself waiting for the S&P to fall below 600 until you're both retired and dead. If the downside to investing now, even under the depression scenario, is better than a 3% average real rate of return over the next decade, I can live with that."

Note: here is a link to an older post on investments.

We're getting there.

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