Could the S&P 500 Index Really Fall 75%? (DIA, SPY, QQQQ)

The calls for another crash are becoming more and more resounding.  The double-dip recession, depending upon its severity, would certainly help the arguments for a potential new market crash… Imagine the DIAMONDS Trust (NYSE: DIA) and the SPDRs (NYSE: SPY) both trading down at $50.00, or worse… and imagine the PowerShares QQQ (NASDAQ: QQQQ) flirting with $20.00 again.  These calls are becoming only more common.

An interesting technical analysis (ZeroHedge) of the historical paths of 20th century bear markets points out that the current bear market, which began in late April, is considerably more severe than average. There is a more than passing resemblance to the market around the crash of 1929.

There is another side note from our technical analysis affiliate Adam Hewison of INO pointing out some of the same but using different metrics in a short audio-video.  On the S&P 500, there is “The Death Cross” as a dramatic technical event where two key moving average cross over in the S&P 500.  Hewison notes that this coincides with all of their trade triangles being negative, and the death cross now is where the 50-day moving average crossed under the 200-day moving average.

Sam Collins of OptionsZone and InvestorPlace also has made some of the same points.

The following chart illustrates the relationship of the 1929-1942 S&P 500 Index to the index for the years 2000-2010. The similarity of the shapes is both uncanny and unnerving.

If the pattern continues, and there is no evidence that there is the political will to stop it, the stock market is headed for a repeat of the 1929 disaster. The absolute low point for the S&P 500 Index during the Great Depression came in 1932, bottoming at about 230. That’s about 85% below its starting point in 1929.

Another technical insight comes from the ratio of the S&P 500 Index to the price of gold. Historically, the ratio reaches a bottom at about 28%. Currently the ratio stands at 94%, at a gold price of about $1,500/oz. That’s higher than the current price of $1,200/oz, but not wildly out of line directionally.

The next chart graphs the S&P 500 Index-to-gold ratio since 1900.

Note that when the ratio hits a high point, it takes about 12-13 years to reach its low point. If the pattern holds, the low point since the peak ratio in 2000 is still two or three years away. By that time, the S&P 500 Index could fall below, well below, 500.

The final part of the analysis relates to contraction of the P/E ratios. The historical P/E on the S&P 500 index averages between 6X-8X EPS. The current ratio is about 19X. That is awfully optimistic.

The last chart shows the P/E ratios during long periods of a secular bear market.

P/E contraction since 2000 is about 50%, compared with nearly an 85% contraction during the 1929-1942 period.  Unless the S&P 500 Index earnings improve dramatically in 2011, there is no historical precedent for the huge P/E expansion that would indicate the beginning of a new, longer lasting bull market.

Whatever one believes about the value of technical analysis, ignoring the past is not a winning formula.

Paul Ausick