Stocks are very expensive. Mr. Market is still in denial.

Bottom line: Declines in earnings and mood could result in an 80% drop in stock prices from here.

The S&P 500 is still priced at over 15 times last year’s earnings ($66 as reported*). Since the late ’90s, corporate earnings have been as inflated as the rest of the economy by cheap credit. From 2003, they spiked up even further, way out of line with long-term trends, largely due to inflated financial profits from the real estate scam and consumer-related and other income from society-wide profligacy. Here’s a 20-year chart:

Click image for larger view. Source: Techfarm

Mean reversion

To make matters worse, in the optimism of the bubble environment, investors extrapolated the recent pace of earnings growth out into the distant future, completely forgetting that growth is mean-reverting. This long-term mean in the US has been about 6% (good luck keeping that up under socialism). Earnings growth will always revert to a mean in a market economy simply because excess earnings attract competition. In an economy with government-supported fractional reserve lending, the downside of the credit cycle will also undercut earnings (and generate large losses).

2006 S&P 500 earnings of $81.51 were an extreme historical anomaly, so applying a 19-handle to them was insanity. If Mr. Market hadn’t been so hopped up on the energy drinks popular at the time, he would have thought long and hard before paying more than $8 for 2006 earnings, especially because stocks were hardly paying any dividends at all.

The first two quarters of 2008 came in with $15.54 and $13.17 in earnings, respectively. If you assume that each of the remaining quarters will be worse than the last by $2 (pretty optimistic if you ask me), you come up with a final 2008 figure of $49.

Mood swings

When thinking about what to pay for those earnings, you want to think about what kind of mood Mr. Market will be in next year. Somehow, I don’t think he’ll be quite as optimistic as of late, since the aftermath of that tuarine/caffeine cocktail can be a downer. After such a frenzy, his mood typically declines for years and doesn’t turn up again until he has put a sub-10 multiple on recession year earnings.

Looking at past episodes, the odds are strong that Mr. Market pays less than $12 for each dollar of 2008 earnings by the end of 2009: an index value of 588 using our ’08 estimate.

But then 2009 earnings aren’t looking so rosy either: even sell-side analysts are predicting that they will be lower than this year’s. Extrapolating a decline of $1 per quarter from our $9.17 estimate for Q4 ’08, you get $27 per the index for 2009. This happens to be about what the 500 earned in the mild recessionary year of 2002. Think next year will be worse? Adjust accordingly.

Whatever your own ’09 estimate, keep in mind that Mr. Market will be downright angry with stocks’ performance and extremely cynical by the time 2010 rolls around. If history is any guide, by the end of 2010 he might not even pay $8 for those earnings. That would be an S&P 500 value just north of 200.

Got LEAPs puts? You can bet on earnings and Mr. Market’s mood out to December 2010 with options on SPY.**

*S&P provides a big Excel spreadsheet of such figures here (download).

**See disclaimer. I own a ton of these.