Meltdown ... and finding cheep stocks

Okay, so it's October 10, 2008, and the S&P500 is down 38% year-to-date.
It should be a good time to look for cheeep stocks, eh?

>Yeah, but how do you measure "cheap"?
Aah, that's the question ... so I consider things like:

>Don't tell me! You got a spreadsheet, right?
Yes, and it looks like this:

>So what are you buying?
I'm thinking.

>But look at them shipping stocks! P/E and PEG ratios, Price/Book ...
I'm thinking!

>But a P/E less than 1? Have you ever seen that before?
Not that I can recall ... but P/E depends upon past Earnings.
What I like even better is Price/Book.

But then the 1-year target prices are interesting, eh?
Just think if that target were actually achieved!
You'd have (for example) a gain of 300% or 400%. Mamma mia!

>But them shipping stocks are unpredicatble, ain't they?
Uh ... yes, they're quite volatile.

>A volatility greater than 100%? Have you ever seen that before?
Not that I can recall ... but it's calculated using the volatility of daily returns then multiplying by SQRT(250).

>So you're recommending them?
You kidding? If I recommend they're sure to crash!

>So what are you doing?
I'm thinking!

Will History repeat itself?

A Look at the future (?)
Here's a fun exercise:

  • Look at the past umpteen years of the DOW.
  • Find a year where the drop was dramatic (as it's been this year).
  • Imagine what'd happen if the DOW performed in the near future as it did in that historical year.

>You can do that?
Sure. There aint no law ag'in it. Did you see the most recent DOW drop, in 2002? Down over 20%.
Here's the comparison:

A $1K investment in the DOW, in the recent past,
compared to the performance starting April 8, 2002.

The near-future DOW (beginning Oct 10, 2008)
if it imitated the 2002 performance.

>But the past is no ... uh, how does it go?
Past performance is no guarantee of future results? Is that what you mean?
Didn't I say this was a fun exercise?

Future: a replica of the past (?)
Okay, suppose we look at the recent past for the S&P500 and ...

>The recent past? Why?
Just in case somebuddy says: "This time it's different".
Anyway, suppose we look at the performance of the S&P500 this century: Jan, 2000 to Oct, 2008 (monthly):

Now we extract the Mean Return and Standard Deviation from that data and predict the next ten years using a classy technique due to Ito.
The red line is where we are now: S&P = 946:

>Probability Density? That means nothing to me. How about ...?
Okay, here's the probability that the S&P500 will be less than P in 10 years (or 120 months):

>What?! There's an 85% probability that it'll be less than it is now?
Actually it's an 86.42% probability ... and I can give you more decimals if you like.

>And you really believe that stuff?
What I believe is that the past gives only vague insight into the future. One needs a more sophisticated tool, like this.

However, suppose we wanted to look carefully at the past and see how long we'd have to wait to get, say a 7% Compound Annual Growth Rate.
We can consider the annual returns from 1928...

>Why 7%?
That's just an example ... now let me continue.
We consider the annual returns from 1928 to 2007 and calculate the Minimum CAGR over all N-year periods and the Maximum.
We'd get this:

>So if I wait 25 years I'm guaranteed to get at least 7.4%?
In the past. Actually, from 1928 to 1953.

That was the worstest 25-year period. The bestest was 1975 to 2000 where you'd have got over 16%.
However, we haven't included inflation, so the "real" returns would have been less. **

>So do you think I'll get at least 7.4% in the future?
You can borrow this

**   If we include inflation, we'd get this:

>Well ... maybe I should just wait longer than 25 years, eh?
If you wait N years your minimum CAGR would look like this: