News flash: Stocks can go down.

Funny how people forget these things. It just goes to show how market prices are at least as much about psychology as fundamentals.

At their core, stocks represent two things: a claim on any future earnings that might be generated, and a company’s net assets. These values are both dependent on people’s sentiments about the future, which swing from optimism to pessimism over time scales as small as an hour or as long as several decades.

Earnings and asset prices are highly variable, especially when debt is employed as liberally as it has been lately. Debt overload destroys economies, because it creates massive distortions in asset prices and risk perception. The boom phase is the destructive phase, because those distortions result in waste. The bust is simply taking an honest accounting of that waste, and it cannot be stopped, and should not be fought, because it restores sanity in the form of market-clearing prices.

Leverage works both ways.

Busts destroy both earnings and net asset values. As asset values drop, leverage increases the destruction of equity.  Lehman, Bear Stearns and others were levered 30:1, so their equity went POOF with just a 3% decrease in asset prices. A retail margin stock account can be levered 3:1, so if somebody put it all into Apple at 180 in August, they would have been wiped out by last week.

Recently, even big industrial firms have levered up so that they could grow-grow-grow and vest those stock options. In the bust, their earnings and asset values (real estate, equipment, subsidiaries) drop, but the debt doesn’t go away. It should therefore come as no surprise that equity values routinely drop by 75% or more in bear markets, but it always does, because each generation has to make its own mistakes.

By the numbers.

Here’s a little back of the envelope calculation I use to sober up the buy-and-holders:

Everyone knows about PEs. For the market as a whole, 10 is pretty cheap, and 20 is pretty expensive. Now, PEs are not everything, since you have to look at the earnings cycle, too. A lot of big gold miners had very high or infinite PEs when the metal was under $300, but they were still a great buy. Lehman and Bear Stearns had PEs last year of about 10.

Earnings for the market as a whole are very volatile. (S&P publishes historical data here — big Excel file available.) Forget about “operating earnings.” I believe it was Charlie Munger, the Berkshire partner who has not turned communist in his old age, who said that every time you hear operating earnings, you should substitute the phrase “bullshit earnings.” What you want are real, reported earnings. PEs should be based on the last year’s bottom line, not what a bunch of ass-kissing analysts are told to tell you they think this year’s or next year’s earnings will be.

So, if we are in a real recession and a real bear market (by the way, real bear markets last at least three years), what does that mean for earnings and PEs?

For this discussion I prefer to use the S&P 500, since it is a broad index with copious data available:

S&P 500 earnings peaked about about $80 for the index in 2006, up from a little trough of $44 in 2001. The index peaked last year a bit north of 1550, for a PE on peak (real trailing) earnings of just under 20. Pretty darned rich when you consider that earnings were about to fall off a cliff, though the aforementioned cheerleaders kept telling us how cheap stocks were at the time.

According to S&P, the first two quarters of 2008 have come in with earnings of about $15.50 and $13.20, respectively, for an annualized rate of something like $57. Apply today’s S&P 500 closing price of 1106 and you see that we are on track for a PE of 19.4 if earnings stay steady from here.

But real bear markets end with PEs under 10. In bear markets, social mood becomes more pessimistic and people have less faith in future earnings. The multiple hovered around 8 in the doldrums of the late 1970s and early 1980s, and bottomed at about 7 in 1932. Let’s be nice and apply a PE of 10 to today’s $57 in somewhat bullshit forward earnings: that of course would give us 570 on the S&P, a drop of over 60% from last October (this would correspond to about 5000 on the Dow).

Think earnings will be even worse next year than in the little 2001-2002 recession? Well, better revise those figures accordingly. I personally assume at least a 50% drop in earnings from 2006 and a PE under 10, for a Dow somewhere under 3500. That is, if all goes well.

Bear markets happen. It’s the stock market, people.

You see, it’s no big deal for stock markets to fall by well over 50%, if not 90%. It’s just big deal for Americans, because they have been lulled into complacency by a 26-year bull market. They should have been saving more all these years, and in a more reliable form than the stock market. Too bad their great-grandparents weren’t around to warn them.