Dear Garden State Trust:
The drop is stock prices has really hammered my portfolio. How much lower can prices go?
No one knows. No one can know with any certainty at this time. I can only provide some context.
The question for all investors will be, are stocks a good investment again? Actually, some stocks may be good investments right now, because not all firms have been hurt equally by the pandemic and social distancing.
One important measure of investors’ sentiment is what they are willing to pay for a stream of company earnings. This is commonly referred to as the price/earnings ratio. Over the long term, the average P/E has been 15.5. As the Roaring ’20s began, the P/E stood at just 5.8. A mania for stock investing drove the ratio to a peak of 31.48 in 1929, just before the great crash. That kind of investor exuberance was driven from the market for about 70 years, until the late 1990s and the Internet investment bubble.
In the early 1980s, when stocks were extremely unpopular, the P/E ratio again fell to single digits. But it wasn’t just the riskiness of stocks that drove investors away, it was the alternatives. Long-term interest rates on safe government bonds rose to an unprecedented 15% in 1981. Why take a chance on stocks when guaranteed double-digit returns are available?
But we know the rest of the story. Fiscal and monetary policies were used to break the back of the 1970s era “stagflation”; interest rates fell; and a great bull market for stocks began. Then came a severe bear market, followed by a recovery, followed by a second bear market.
Then we had the longest bull market in history, followed by an unprecedented national health emergency. The extreme volatility is likely to continue until the full ramifications of the virus becomes known.
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