When will stocks stop tumbling?
Watch: The Fed
Current read: A summer rally
This spring the stock market has flirted with the 20% decline that would mark an official bear. Now what every investor wants to know is when stocks will start climbing back.
What to watch: Again, follow the Fed. "Interest rates are probably the one thing that you really want to pay attention to," says Sam Stovall, chief investment strategist for Standard & Poor's Equity Research. Of the dozen times the Fed has embarked on a series of rate cuts since 1954, the S&P 500 has only once failed to deliver a gain one year later.
Why are rate cuts such a reliable predictor? Over the long term, stock prices follow corporate earnings, and while analysts use all sorts of methods to place a value on future earnings, one principal remains constant: The lower rates are, the more valuable future earnings are to investors.
For a second opinion: Not convinced by the march of history? Check out stock valuations. When share prices are cheap relative to earnings, the market is poised to take off.
One way to judge cheapness, says Stuart Freeman, an equity strategist at Wachovia Securities, is to compare the earnings yield of the S&P 500 - the inverse of its price/earnings ratio - to the yield on government bonds. The more the S&P 500 is yielding vs. bonds, the more inexpensive it is - and the more likely a recovery is.
What they're saying now: Based on rate cuts, the stock market should be going on a tear any minute now. But since the Fed began to lower rates last September, the S&P 500 is down about 8%.
Stovall believes that the market's prognosis is still positive for the fall. The earnings yield backs up that forecast. The price/earnings ratio of the S&P 500 stands at 16, making the earnings yield 6.3% (1 divided by 16).
The yield on the 10-year Treasury bond is only 3.6%. In March 2000, right before the market collapsed, the earnings yield was 3.9%, while the 10-year Treasury was paying 6.3%. "That would suggest that stocks are as cheap today as they were expensive back in 2000," says Freeman.
To keep track: The Federal Reserve Bank of New York posts rate cuts in the Markets section of its Web site. For the earnings yield, look up the S&P 500 P/E ratio in the Numbers section of our magazine (page 130) and then divide 1 by that figure. Find the yield on the 10-year Treasury bond at our Bond Center.
The wild cards: A long, painful recession that hits corporate earnings hard or a spike in inflation that forces the Fed to start hiking interest rates again.
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