Dow Down 370

THE BE YOUR OWN ECONOMIST ® BLOG

Everyone’s talking about the world-wide financial crisis, and that may have been the main driver behind today’s 370-point-loss on the Dow. But don’t forget the effect of the recession that’s unfolding.

It will do two things: Erode earnings and reduce the P/E. Both of these developments will further depress the stock market.

Corporate earnings have done very well since the 2000 – 2002 dot.com bust. Now, with the recession, they’re headed for the basement. That alone would be bad for the stock market.

In addition, earnings’ strong performance since the dot.com bust kept the P/E (price/earnings) ratio above its historical average. Strong earnings inspired investors to maintain a high price for stocks relative to earnings. But falling earnings will erode confidence, further depressing stocks.

Tomorrow’s posting will mobilize a set of charts to illustrate these points.

© 2008 Michael B. Lehmann