How Low Will the S&P 500 Go?

USA Today’s Matt Krantz considered an interesting premise at 4:59 PM EDT on 21 August 2015, just after the Dow Jones Industrial average lost 531 points and the S&P 500 lost 65: “How low the stock market can go“.

After seeing 6% of their money evaporate this week to drop 8% from the recent highs- investors are wondering how much uglier things can get. The answer is: much.

The Standard & Poor’s 500 fell another 3.2% Friday – dragging the index down below 2000 at 1970.89. Seeing such a rapid decline is a reminder this bull market has gone untested for too long and the pain could get worse – much worse to bring valuations back in line with reality.

“There will be more wringing out of this market. There’s been too much optimism,” says Chris Johnson of JK Investment Group.

Trying to guess how low a market under pressure can go is far from precise. Markets can overshoot on the downside just as they can soar too much on the upside.

Considering that we’re the probably the only analysts who appear to have successfully foreseen the specific market action of the trading week ending 21 August 2015, well in advance, we have some insights that might be relevant to consider on how much lower stock prices might go.

Let’s first consider the immediate situation, in which the U.S. stock market has racked up a 4-day long losing streak. Based on 16,506 days worrth of historical data from 3 January 1950 through 7 August 2015, the odds were approximately 1 in 73 going into the previous week that such a long losing streak would be recorded.

Meanwhile, the odds that the market will see a 5-day long losing streak are roughly 1 in 135. Based on these figures, the probability that the U.S. stock market will extend its current 4-day losing streak to 5 days is about 46%. So the odds slightly favor the immediate losing streak coming to an end.

But that assumes some degree of general randomness in stock prices, which as we’ve long since established, is a relatively limited factor in driving stock prices, with its main channel affecting their day-to-day volatility through the interactions of millions of investors conducting billions of transactions.

Since they’re not really random, but are instead driven by the expectations that investors have for the changes they expect in the growth rate of the dividends per share they can reasonably expect to earn at specific points of time in the future, let’s take a look at what likely lies ahead.

At present, investors would appear to remain focused on the expectations associated with the current quarter, 2015-Q3, which will end in September 2015. This focus has largely been directed by the forward guidance that the Federal Reserve has steadily been providing with respect to its plans to begin hiking short term interest rates over the last several months.

With that being the case, so long as U.S. investors remain focused on the current quarter, we can reasonably expect that stock prices will generally parallel the trajectory indicated in the chart above, within a relatively narrow margin of error as consistent with the typical day-to-day volatility of stock prices.

Given the relatively narrow difference between the alternative future forecasts that apply for when investors might be focused on either 2015-Q3, 2015-Q4 or 2016-Q2, we would anticipate that stock prices are likely within about 3% of where they will bottom in the near term. However, should investors shift their forward-looking focus to 2016-Q1, as might happen if investors adopted the view that the global economic situation is such that the U.S. Federal Reserve will back off its plan to begin hiking short term U.S. interest rates in September 2015, stock prices would likely fall an additional 6-9%.

There are however two wild cards to consider. First, should the expectations for future dividends deteriorate, such as might happen if major U.S. oil producers act to cut their cash dividends in response to declining revenues resulting from falling global crude oil prices, stock prices will fall below the levels indicated in the charts above as the basic fundamental factor that drives stock prices will have been negatively impacted.

Second, a significant noise event could cause stock prices to deviate from the likely trajectories shown in our alternative futures forecast chart above. As these kinds of events are largely driven by speculation in the market in reaction to the random onset of real world news events, which is the other channel by which stock prices are affected by random factors. Although transitory in nature, such noise events can significantly affect the level of stock prices until they dissipate.

If you were looking for absolute certainty about where the market is going, you came to the wrong place. If however you were simply looking to get a better handle on what is happening within the U.S. stock market for the sake of making better informed investment decisions as global markets go through a period of panic, you’re welcome.