IT can be a bummer to pick up the paper these days. There is disturbing news about the pace of the economy in the United States, the resolution of the sovereign debt crisis in Europe, the slowdown in China, the civil strife in Syria, Iran's nuclear development program and finally the shootings in Colorado.

If that isn't enough to get you down, there's the Libor rate-setting scandal, the higher-than-originally-announced trading losses at JPMorgan, the telephone hacking by reporters in the UK and the fraud at Peregrine Financial. Heroes in finance and elsewhere are being brought down daily, it seems. It's hard to be upbeat.

I have begun thinking that the dark mood these events are creating may be reflected in the valuation of equities. Price-earnings ratios, after all, are a reflection of confidence, and with all that's going on, confidence in the future is waning on many levels.

The poor performance of equities over the past decade - together with the "flash crash," the high-frequency trading and the thought of computer-driven algorithms determining the course of the stock market - has driven individual investors out of equities and into bond funds. Many wonder what will bring them back.

I remain optimistic about the outlook, but I have to recognize that the pattern of negative events, together with a subdued growth outlook in the developed world, may mean that historical multiple ranges could be undergoing a process of downward adjustment.

Looking at the Standard & Poor's 500 since 1945, the average annual earnings growth rate has been 8.4 percent and the average multiple has been 15.4. On that basis, the index at 1,380 seems undervalued if operating earnings come through at US$100, as the consensus expects.

Competition intensified

The problem is that the US is now a mature economy and world competitive conditions have intensified. From 1945 to 1980, when Europe and Asia were rebuilding after the war, economic growth in the US was easier to achieve. When other developed economies began manufacturing and exporting, business conditions became tougher. After 1990, China and India entered the arena, and the environment for growth became even more difficult.

In their book This Time Is Different, Carmen Reinhart and Ken Rogoff argue that when a country's debt to gross domestic product (GDP) ratio reaches 90 percent, it becomes harder for real growth to exceed 2 percent because the use of leverage becomes more problematic.

If you assume real growth for the U.S. of 2 percent, plus 2 percent inflation, plus 1 percent productivity improvement, we may be in a period where nominal earnings growth is only 5 percent, compared with the historical rate of 8.4 percent. If the average multiple on a growth rate of 8.4 percent was 15.4, does this mean that the average multiple will come down proportionally?

If that were the case the multiple going forward would be 9.2 and the fair value for the S&P 500 would be below 1,000.

Even the shrillest of the bears isn't projecting a level that low.

Interest rates have to be taken into account, of course. For years I used a dividend discount model based on the fact that stocks competed with bonds for investor capital. When the 10-year Treasury began to attract "fear capital" a decade ago, Treasury yields dropped to aberrationally low levels and the model lost its predictive value.

With 10-year Treasurys now yielding 1.5 percent, the model would indicate a multiple well in excess of 20. I find it hard to believe that the multiple for the S&P 500 would drop below 10, but the median price-earnings ratio could drop to 13, making the market today somewhat overvalued rather than undervalued. I am not quite ready to go there yet, but I wanted to introduce it as a possibility

'Reversion to the mean'

What we're dealing with here is the hallowed "reversion to the mean" concept. The world has become more complex, more competitive and perhaps more corrupt. Economies have become more indebted and governments, certainly in the developed world and perhaps also in the developing world, have become dysfunctional. These qualitative factors would argue that multiples should be lower as well.

With the background for equities looking so bleak, it's probably useful to explore what could go right. The pattern of both the economy and the market over the past two years has been for the first quarter to be positive, the second and third to be weak and the fourth to be strong. Could that be repeated this year? From a market standpoint, conditions are promising because sentiment is understandably negative for all the reasons we've already discussed.

Fundamentals to turn

We need the fundamentals to turn, however. Unemployment has to come down, but that could begin to develop because initial unemployment claims have declined sharply. Real growth has to climb above 2 percent, and the fledgling recovery in housing could make that happen. The decline in gasoline prices is putting more money in consumer pockets and that could help during the all-important Christmas shopping season, although recent data on retail sales have been disappointing.

I think the report that China's second quarter real GDP came in at 7.6 percent takes the "hard landing" possibly off the table for a while, although critics are questioning the accuracy of the figures.

The most important cause of uncertainty is Europe, and it is hard to be sanguine about conditions there. Europe needs significant structural change to resolve the sovereign debt crisis. The markets were reassured when agreement on the formation of a banking union was reached several weeks ago, but hammering out the details will take time, and even that step doesn't deal with the fundamental problems.

While Spain and Italy may be able to continue to borrow at rates which will prove unsustainable in the long term, their credit markets are not open to the private sector. Germany and other austerity hawks have softened their stance on deficit reduction for the weaker countries, but it looks like Europe will be in a recession both this year and next with high unemployment leading to the possibility of social unrest.

Mario Draghi has said that the European Central Bank will do "whatever it takes to preserve the euro and it will be enough.

We all know what Europe ultimately needs is a fiscal and political union, such as we have in the United States, although it could be argued that it hardly works perfectly here. Numerous critics have pointed out that a political union would be impossible because of language and cultural differences. Even if you set these aside, there is currently no leader in Europe capable of convincing the people in his or her own country that convergence to this degree is a good idea.

According to the Boeckh Investment Letter, France, Italy, Spain, Portugal and Greece will need 18 months of financial aid to fund debt rollovers and deficits. Aside from the financial needs of the governments themselves, the banks in those countries will require almost a trillion euros to cover debt rollovers, loan losses and Basel III capital requirements. Where will all this money come from?

Borrowing money

The stronger countries will be able to borrow money from the European Central Bank because they will be able to demonstrate that they can pay it back. The weaker countries may have to leave the European Union and print money to sustain their economies. Obviously, it would be a turbulent period, but I believe that's where we may be heading. The steps taken recently defer the problems into next year while the continent prepares for the inevitable.

Trouble in the European Union began with the financial crisis of 2008. From the time the euro came into being until then, the so-called PIIGS (Portugal, Ireland, Italy, Greece and Spain) had been reducing their debt to GDP ratios. Now, keeping the Union together just appears to be too costly and would endanger the financial integrity of the stronger countries, which would be bearish for the rest of the world.

In the end, the break-up could turn out to be a positive because holding together what is unsustainable has cast a pall over the financial markets. Establishing a union of the stronger countries and putting the weaker ones back on their own will result in some dislocations, but a major cause of uncertainty would be removed from the markets and that could prove to be an important change.

The opinions expressed are his own. Shanghai Daily condensed the article.