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We’ve seen some rocky times in the stock market
lately. Up one day. Down the next.  The stock market
has declined over 10% in the past month. Whenever
the market is in a downward spiral, people wonder,
“How low could this possibly go?”
.  It went down over
50% from it’s high to low in the financial meltdown
aftermath through early 2009. It went down 90% in the
depression. How far can it go down now?

If a nuclear war started tomorrow, or some other
equally catastrophic event, how much would the stock
market decline? What would prevent it from losing
100% of its value? What would prevent it from losing
80% of it? I think the 80% scenario is certainly
possible under certain conditions. Let’s take a look.  

Catastrophe happens; on the one hand you might
have panic selling where the fear of losing it all grips
the market.  On the other hand, there is always a
constant real demand for assets, financial or
otherwise. That is, money has to go somewhere, even
if it sits in a cash account at a bank. Even in bad
economic times. Even in times of crisis. Whether it’s
in a checking account, money market account, stock,
or goes for the purchase of a physical asset, money
has to go somewhere. If you purchase a physical
asset, that money affects the price of that asset. If you
purchase the any financial asset, even the safest one
because there is a crisis will provide a buffer to its
price. Collective action of this kind provides one lower
limit for the price of securities.

One way to look at the potential degree of a future
stock market decline is to look at the past money
flows out of the stock market and the accompanying
dip in stock prices during previous crisis. If we take
the full year 2008 as an example, (a good year to
measure full year money flows during an extreme
market downturn), we see that the net outflow from the
stock market into cash (money market instruments)
from all other funds was $750 billion. This was about
12% of the total beginning year equity market value,
yet the Dow lost 25% of its total value by year-end. So
we see a broad relationship between the outflow and
the price decline of the market. This is just a rough
proxy of the connection, but we can calculate ballpark
figures of what would happen to prices if a bigger
crisis, and a larger stock market outflow occurred.

At the same rate as above, a 30% outflow to cash
would result in at least a 63% drop in the Dow. In
practice, I believe the Dow to go even lower because
the relationship of outlows-to-cash to lower Dow price
will become even more extreme as the markets go
down.  The question might really become what are the
likelihood of a crisis that would scare investors
enough to cause a 30% or more outflow from the
market. How much more will sit in cash accounts
under which circumstances.  Of course we know the
price drivers are more complex than this, but the
money flows are a big driver, especially in the short
run.  

Here’s another way to look at what would provide a
floor for stock market prices in a crisis. It is an
approach akin to value investing principles. While it
has merit IMO, I believe it only truly applies to
economic or market downturns, where rational
investing is still taking place, as opposed to true
crisis, where it may not be. During these downturns,
the flight of money will go to “value”, or “income”
stocks, primarily of large well capitalized stocks in
staple industries. Money will come out of high growth,
non-essential product industries, or speculative
stocks. But the money will largely stay in the equity
market.   

One key aspect of the price floor buffer provided from
these value companies is that they provide a steady,
relatively high dividend yield. For instance, a stable
value company may provide a 4% dividend while a
speculative tech stock may pay none. So the 4%
company becomes a relative haven for money
because investors know that they will get a stream of
cash back out into the future. That dividend cash
becomes a near proxy for selling equities altogether.
Since these companies core businesses fare better
in poorer economic conditions, and they throw off
cash, money flocks to them during these times. This
provides the demand for a price floor for this part of
the market.

Speculative stocks, and those stocks that are not
profitable, or close to being profitable, would have a
much lower possible bottom. So a typical broad
relative price scenario relationship might be that if the
value stock goes down 10%, the speculative stock
may go down 20% or more.

A third angle for predicting a stock market price floor:
the crisis event happens. Money flows out of stocks
into cash and equivalents. The period just after this
produces a dynamic that brings some of the money
back into stocks. The money goes into interest
bearing instruments such as money market securities,
Treasury bills/bonds and safe corporate bonds.
However, this pushes the yield on these securities
down. You see this in the current markets. Yields on
the ten-year treasury bonds have gone from a high of
3.6% in early April down to 2.0% today. The yield has
dropped 0.8% in just the month of August. Those
looking for the security of their principal may not care.
At some point investors must consider what they want
to earn on their money and what the risk is to do so.
Reevaluation of the stock market, especially at post
decline valuations, will show forecasted total stock
returns too much higher than 2% for investors to
ignore, and the money will start drifting back into the
stock market, establishing a floor for the decline.

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