How Low Can You Go? - TheStreet

How Low Can You Go?

Just how much damage can a slowing economy bring to this high P/E market?
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A key question facing stock investors today is, "Just how bad is the economic slowdown and how far down will it take corporate profits and stock prices?" The market's September swoon tells you that profit growth is expected to slow with the economy.

The reasons why are not hard to see. Oil prices keep on rising. There have been 129 central-bank tightenings over the past 15 months, according to the folks at

International Strategy and Investment

. And the old wealth effect has ceased with the slide in stock markets here and abroad.

Let's do a thought experiment to estimate how far down the economy might take the market. Let's use the

S&P 500 index as our benchmark. It has a bunch of tech and other big-cap stuff in it.

When markets go down, two things happen. Earnings growth slows, and

price-to-earnings multiples compress. Earlier this year, Wall Street strategists estimated that earnings for the companies that comprise the S&P would grow 33% over the next 12 months. More recently, they have reduced their estimated growth rate to a still-generous 24%. That gives you earnings per share of $64.91, according to analyst Sam Burns at

Ned Davis Research

.

Now let's say that P/E's get squeezed.

They should because a price-to-earnings ratio is nothing more than the price investors assign to a given stream of future earnings. (Given the economic uncertainty, people will pay less for two in the bush.)

How much compression is reasonable? The S&P 500's trailing P/E is now about 29. The historical average since 1970 is 15.8, but let's be more generous. Let's say that in a worst-case scenario, P/E's revert to 20.

If these two events take place, what happens to the S&P? Now, apply a 20 times price multiple to the $64.91 in earnings, and you get an S&P at the 1298 level. The S&P closed Wednesday at 1451.34.

So this quick and dirty analysis implies a 10%-11% drop in the market. It ain't a nightmare, but it's less.

Why don't I think this turns into a full-fledged bear market? In part, because we are already off the all-time highs set earlier this year. The S&P is off about 4%, the

Dow is off a good 8% and the

Nasdaq Composite is down about 23%. More importantly, I feel that way because we do not have the kind of major imbalances in the financial system that could cause financial panic. The biggest imbalance is the high valuation of the U.S. dollar, especially in relation to the sickly euro.

Frankly, I do not find the dollar

an overwhelming worry. Why not, given that the trade deficit hit a new high in July? First, rising oil prices are actually good for the dollar. Oil prices are denominated in dollars, and thus the price hikes increase the demand for greenbacks.

Second, America remains the best place to commit large pools of capital to high tech in a politically stable nation. Europe, like the euro, continues to struggle toward economic union. The Danes are not sure they want to join the euro bloc. The

European Central Bank

is weak. Structural reform to speed economic growth is happening slowly. European governments can't even stand up to oil-price protests, let alone push labor-market reforms. These are not the kind of conditions that suggest a massive flight from the dollar to the euro.

Stock investors are going to have to deal with slightly less cosmic issues -- slowing earnings and compressing P/E's. We'll just have to sweat it out.

Brett Fromson writes daily for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks, although he owns stock in TheStreet.com. He also doesn't invest in hedge funds or other private investment partnerships. He invites you to send your feedback to

bfromson@thestreet.com.