Recipe for a meltdown

(Fortune) -- With the S&P down over 10% from its October record high, TV pundits and Wall Street strategists are blaming the most obvious culprits for the sudden reversal of fortune, chiefly the subprime crisis and the looming threat of a recession. But it's neither the credit crunch, nor a slowing economy -- nor a third hobgoblin, the weak dollar -- that pushed the markets into correction territory Monday.

The real reason is so basic, and so antithetical to Wall Street's habitual happy talk about stocks, that it barely rates a mention in the market chatter. Put simply, stocks are extremely expensive relative to the daunting risk in owning them. At current prices, earnings can't possibly grow fast enough to give investors the fat returns they covet.

There's just one way for equities to get their lustre back -- their prices have to fall substantially so that investors can harvest attractive returns from the modest profit growth that's in the cards. Like the biblical sheik who hastens to Samarra to escape death, only to find death waiting for him there, stocks have an inescapable appointment with a withering fate.

Naturally, stocks could bubble back to their old heights in the next few weeks or months. If the recent past proves anything, it's that the course of equity prices is totally unpredictable from day to day or quarter to quarter. As the economist Milton Friedman once told me, after returning my call collect, "Stock prices are rational in the long-term, but in the short-term, they're far from rational. They're full of noise."

But don't let the Wall Street crowd fool you into thinking that the current decline is mostly noise, an irrational blip in a bull market caused by a spate of bad news. What we're probably witnessing is a massive, irreversible revaluation of stocks based on fundamentals. The repricing machine is now in motion. The smart money says it won't stop, despite feints and lurches, until stocks are a bargain again, a prospect investors haven't seen in years.

Why are stocks at a probable turning point? The reason is that investors' perception of the potential perils of holding equities has changed substantially in the last few months. In any major shift, it's impossible to predict what the catalyst will be. In this case, it was the subprime mess. Again, subprime was the catalyst, not the cause. It wasn't just a crisis that would pass, as the pundits argued, but a flashing red warning that triggered a durable shift in investor psychology.

Before the credit crisis, investors took an incredibly blasé attitude toward risk. Yields on junk bonds, corporate debt, and office buildings were at all-time lows. Then subprime struck. Suddenly, investors recognized that the rates on high-risk mortgages didn't come close to reflecting the high probability that homeowners would default on their mortgages. So the prices of subprime paper plummeted. The downward pull on prices spread to all types of fixed income securities, from all types of junk bonds to LBO loans.

Now, the fear of risk is spreading to equities with a vengeance. The problem with equities is that the repricing following the bubble of the late 1990s never fully played out. Stocks roared back from their 2001 lows, reaching record levels this fall. The rub is that they were, and still are, extremely expensive.

The best way to measure whether stocks are giving you enough juice for the risk you're taking is examining the equity risk premium. This is the ultimate number in corporate finance, what Dartmouth economist Kenneth French calls "the holy grail" of stock investing.

Let's run through some simple math. The best measure for the future return on stocks is the earnings yield, the inverse of the price-to-earnings (PE) ratio. Today, the PE, based on trailing 12 month earnings, is around 16. That's not too far above the historic average of 14. Even by that measure, stocks are far from cheap.

But the 16 PE isn't the whole story. Earnings are now near a cyclical peak, having jumped more than 60% since 2001. They're now more than 12% of GDP versus an historic average of around 9%.

Over long cycles, earnings grow in tandem with GDP. It's likely that they will grow more slowly than national income over the next few years to restore the normal ratio. That prediction makes sense: Many of the factors that led to the earnings explosion are now shifting. Rates for corporate borrowing have increased substantially, companies are being forced to invest far more capital equipment to remain competitive, and labor is demanding a bigger share of the pie.

To get a more accurate read on the PE, it's critical to smooth earnings to take out the spikes in the cycle. Yale economist Robert Shiller has developed a profits-smoothing formula that does just. The Shiller model now puts the PE at around 22 or 23, reflecting today's sumptuous earnings.

So where does that put the equity risk premium? With a PE of 22, the earnings yield is just 4.5%. So the return investors can expect from equities is 4.5% plus expected inflation of 2.5%, or around 7%. To get the equity risk premium, subtract that expected return from the 10-year treasury rate of 4%. That's the extra lift investors get for choosing the perils of holding stocks over the comfort of owning government bonds.

At 3%, the equity risk premium is low by historical standards. The recent decline has helped make it more attractive. But the drop hasn't gone far enough. Over the past 50 years, the risk premium has averaged around 5%. Maybe investors don't need that big a spread today, given the ease of diversifying portfolios and the Fed's ability to smooth economic cycles. So let's say the number is now 4%. To get there, stocks still need to drop an additional 18%.

The most dangerous sector is technology. Just look at the lofty PE's. The big names like Microsoft (Charts, Fortune 500) and Intel (Charts, Fortune 500) boast multiples of between 20 and 25, yet they're now giant, mature enterprises that, because of their sheer size, can't grow profits nearly fast enough to justify their high prices.

For the Googles and Yahoos, the outlook is far scarier. Google's PE now stands at 52. Say you're expecting a 10% a year return from Google (Charts, Fortune 500). Its market cap would have to double to more than $400 billion by 2014. Even if Google kept a stellar PE of 30, it would need to earn $13 billion by then. Today, it earns about $4 billion. So its profits would need to more than quadruple in seven years. It won't happen.

For the bulls, the coup de grace is the math -- earnings growth cannot bail out the market. The reason is that what really counts, earnings per share, don't even grow as fast as GDP. That's because companies regularly issue more shares and dilute their current shareholders -- the explosion in stock options is only the most obvious example. Because of the big dilution, earnings per share grow far more slowly than GDP; the best estimate is around 2%, adjusted for inflation.

Investors can't get fat returns from profit growth. But they can get good returns from a combination of far higher dividend yields plus modest profit growth. And for dividend yields to rise, prices have to drop. That's the inexorable math we now see playing out.

Forget the chatter, ignore the headlines, and follow the math. Prices will get a lot more attractive. The process is underway. All investors have to do is wait.

PS: Yes, I know the Dow was up 331 points on Wednesday. But that just gives the market even more room to fall.