Most equity markets have lost more than 50% since October 2007. Current levels again represent value for long-term investors.
Using normalised company profit levels and the Standard & Poors 500 average P/E ratio over the last 80 years, an investor can expect a real annualised return of 8% going forward. The economic and financial uncertainties dominating the current environment mean that in the short term, stock markets will continue to experience high levels of volatility. Against this backdrop, a further fall in share prices should not be ruled out. Any further decline in stock prices from current levels will only increase the long-term returns that investors can expect over time, however.
The conclusions of the previous paragraph are based on the following assumptions. If we normalise company profit margins (which reached record highs in 2007), we can estimate average earnings per share for the S&P500 Index at $64 in 2008. Over the past 80 years, investors were willing to pay on average 15 times company earnings. If we apply this P/E ratio of 15 to the normalised profit of $64, we get a value for the S&P500 index of 960, which can be considered its fair value. From this level, the market should offer an annual real long-term return of 6.5% (the historical average). Below 960, the expected return will be greater than 6.5%; above 960, it will be lower than 6.5%.
If we take 960 as our starting point and assume an annualised return of 6.5%, the S&P500 would reach 1800 in ten years' time. Given that the S&P500 index currently stands at 820 and not 960, this would mean an 8% real annualised return from today's level.
It is important to point out that the above reasoning is only valid for a long-term investor. Using it as a starting point, we can build more or less optimistic or pessimistic short-term scenarios. For example, we could argue that for investors to buy equities in the current economic environment, the S&P500 would have to be trading at a discount of at least 30% to its fair value. This would imply a level of 670, which is around 20% below last Monday's closing. The diagram below summarises a range of possible scenarios.
By eliminating the extreme scenarios and taking into consideration the particularly uncertain economic environment we can narrow this diagram to a range of 600-1000. This would argue in favour of a strategy consisting of gradually increasing equity weightings below 800. Even if the above reasoning is based on the Standard & Poor's index in the United States, this level can also be used for establishing equity exposure in Asia and Europe, the more so since these markets take their clue from the US market anyhow.
