Why US stocks could fall another 20%

The Dow Jones marked the 20th anniversary of Black Monday with a 367 point fall on Friday. Whilst nothing like as bad the 22% slump seen on that dark day in 1987, it has certainly re-awakened worries of what may lie ahead.

Friday marked the 20th anniversary of Black Monday.

On that day, the Dow Jones Industrial Average fell by 508 points. Doesn't sound like that much today, but in fact that was a 22.6% fall, equivalent to more than 3,000 points today.

So by those standards, Friday's 367 point fall wasn't anything to write home about.

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But it's certainly re-awakened worries of what may lie ahead

On Friday, the S&P 500 fell 2.6% to 1,500. That was its worst one-day fall since "the credit squeeze hit in mid-August," reports the FT.

So why the sudden panic, just as everything seemed to be right with the world once again?

A few things are troubling investors. For one, third quarter earnings results. Conglomerate Caterpillar saw its shares drop by more than 8% as the group warned that full-year results would miss Wall Street hopes. It said that several of the industries it supplies are in recession, with the weak housing market in particular hurting sales of machinery.

Meanwhile, sales at both 3M and Honeywell also fell short of Wall Street's expectations in the third quarter. All of this hammered already fragile investor confidence.

The trouble is, the new story gripping the markets is the idea that, effectively, the US doesn't matter anymore. Asia and the rest of the world can happily keep growing and keep companies' coffers expanding without the US consumer to prop them up so why not buy shares in those companies most exposed to the global growth story and let America go into hibernation for a while?

It's a nice story. But as Bill Strazzullo of Bell Curve Trading put it: "A company like Caterpillar should be a poster child for global growth and the benefits of the weak dollar." So if it can't make hay while the sun is apparently shining, then who can?

"It makes you question: is global growth really that strong? Has the earnings kick from the weak dollar played itself out?"

John Authers, also in the FT, points out something else to worry about. It's not just Caterpillar that's disappointed so far "the 22% of S&P 500 companies to have reported have on average, reported a decline in earnings of 14.8%" for the third quarter, he says.

Now, this is partly because many of the results so far have been from financial companies, which of course have suffered severely in the credit crunch. But even so, overall analysts now reckon third quarter earnings in the US will shrink, for the first time since 2002, by 3.7%. That's against initial expectations for 7.1% growth.

The reason that shares have held up so well so far is that markets are expecting a rebound this quarter (the fourth) and during the first three months of 2008. But as Authers points out, "profit margins, like economies, tend to revert to a long-term mean."

In other words, the higher they are, the more likely they are to fall. And Rob Arnott of Research Affiliates tells Authers that "earnings are currently 60% above their 10-year average." According to Arnott, "the average 10-year growth in earnings after they get 50% or more above their 10-year average is zero."

So Arnott is basically saying that over the next 10 years we should expect earnings growth from S&P 500 companies to average zero. That's not good news for stocks which are, after all, priced according to future earnings expectations, give or take the odd mania or two.

That means "there is every reason to fear that earnings growth will fall sharply next year, even if the US and the developed world can avoid a recession."

And that last is a big if, with the US housing market showing no sign of improving.

Even though he's bullish on stocks in the longer-term (see Avoid property - but I think shares are good value), economist and stockbroker James Ferguson thinks we may well see another large correction (we're talking about near 20%) in the near future as markets start to realise that the US economy isn't going to get any better.

Turning to the wider markets

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London's FTSE 100 index closed down 81 points, at 6,527, on Friday as the opening slump on Wall Street struck a blow to already desultory shares. Resolution was the day's best performer after announcing its long-awaited bid for Pearl. However, banking stocks - most noticeably Northern Rock - dominated the FTSE fallers. For a full market report, see: London market close.

On the Continent, the Paris CAC-40 lost 26 points to end the day at 5,740. And the Frankfurt DAX-30 was off 37 points, at 7,884.

Across the Atlantic, US stocks marked the 20th anniversary of Black Monday with a heavy losses. The Dow Jones plunged 369 points to close at 13,519 as components 3M, Honeywell and Caterpillar all reported disappointing earnings. The tech-laden Nasdaq fell 74 points to end the day at 2,725. And the broader S&P 500 was down 39 points, at 1,500.

Asian stocks took their lead from Friday's fall on Wall Street today. The Japanese Nikkei was down 375 points at 16,435, and in Hong Kong the Hang Seng had fallen 1,091 points to 28,373.

Crude oil futures peaked at $90.02 in New York on Friday but had fallen back down to $88.00 this morning. And Brent spot was down over 1% to $83.87 in London.

Spot gold fell by 1% in Asia trading as investors took profits on last week's rally. The yellow metal was last trading at $760.60, having hit a low of $754.00 earlier in the session. Silver, meanwhile, was down to $13.44.

Turning to the currency markets, the pound had fallen back from a two-month peak of over $2.05 against the dollar this morning and was last trading at 2.0486. The pound was at 1.4322 against the euro whislt the dollar was at 0.6984. And the dollar was at 113.95 against the yen.

And in London this morning, Ernst and Young's economic research group, the ITEM Club, said that a UK economic slowdown would be 'no bad thing' as it would prevent overheating in the financial services sector. The group has also cut its 2008 UK growth forecast from 2.5% to 2.1%.

John Stepek

John is the executive editor of MoneyWeek and writes our daily investment email, Money Morning. John graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news. John joined MoneyWeek in 2005.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.