How Low Can Stocks Go? July 12th, 2021

The purpose of this story is to inform you as to what's possible in a near worst-case outcome for the financial markets. The reason is to understand what's possible, though unlikely, so you can plan soundly for your financial future unemotionally. The US stock market is the greatest wealth creation machine in the history of the world. I want you to benefit from it without making emotional mistakes with money.

Too often when we have a rare short-term downturn in the markets, it's too late to offer up information that might have been helpful ahead of time. Stocks generally reached new record highs last week as we’re heading towards the start of earnings season with inflation fears currently in check, along with a general belief that any of the Greek alphabet variants of COVID-19 won’t become showstoppers. 

Earnings season is expected to be spectacular. Current estimates call for second-quarter earnings to grow by 64% year over year as companies will replace last year’s pandemic lockdown quarter with what we just produced. Should that happen, it’d be the strongest quarterly gains for earnings since we emerged from the depths of the Great Recession over a decade ago. That earnings follow-through will be necessary to help justify stock prices at current levels. Meanwhile, cryptos are continuing to struggle which has continued to lead to an influx of money into stocks. 

As we enter this week, here’s where the market stands based on fundamentals using the S&P 500 as the example.

  • S&P 500 P\E: 46.42
  • S&P 500 avg. P\E: 15.98

The downside risk is 66% based on earnings multiples right now from current levels. That's 30% more risk compared with this time last year. The market remains historically expensive right now. Stocks are priced for earnings to continue to rebound. If the economy does continue to recover as expected, stock prices can be justified. If something were to come out of left field, there’s clearly a lot of room for a downside. That’s basically where we are right now.

It's always important to ensure that you're positioned for negative adversity. If a 66% decline wouldn't affect your day-to-day life, you're likely well-positioned. If not, you should probably seek professional assistance in crafting your plan that balances your short-term needs with long-term objectives.

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