Dip buyers have been wading back into the market. Stocks have risen in four of five sessions, lifting the index almost 7% from its intraday low Friday. A weakening dollar, less-hawkish Fed commentary and decent retailer earnings did some of the lifting. Behind them is a prayer that the $8 trillion drawdown since January has left prices less vulnerable to economic shocks.
After falling 15% this year, the S&P 500 is trading around 4,000. According to analysts tracked by Bloomberg, its members will earn a combined $248 a share next year. Divide price by earnings, and the result is a forward multiple of 16 — roughly in line with the three-decade average. So not dirt cheap, but perhaps reasonably priced.
The calculation in the above exercise is based on forecast earnings, the reliability of which is suspect, especially when the Fed is raising rates. Analysts have a long history of missing downturns. Case in point is the start of 2008, eve of the global financial crisis. Estimates at the time called for a 15% gain in S&P 500 profits.
Treating historical Price/Earnings as reliable signposts for a floor is risky too. With inflation raging and the Fed committed to an aggressive tightening campaign, the backdrop is one of the most ominous for equity valuations in decades. In bear markets, stocks rarely stop falling at the average P/E. Rallies like this week’s are common features of much bigger plunges.
History holds numerous examples of stocks that looked like bargains relative to forecasts but ending up as anything but. Since World War II, corporate income has tended to drop a median 13% around economic retrenchments.
Timing the top of a growth cycle is next to impossible. But for the sake of illustrating the point, assume Corporate America is able to deliver on what it is expected to earn this year: $227 a share. Then assume a recession hits and profits shrink by the 13% in 2023 that is typical of an economic contraction.
In that scenario, S&P 500 profits would be $198 a share, rather than the $248 now projected by analysts. And instead of sitting at a reasonable-looking multiple of 16, stocks would be priced at a Price-Earnings ratio of 21.
It begs the question of what’s the proper valuation for equities. The picture as things are now, shows stocks as still moderately expensive relative to the history of the post-crisis bull market, but quite cheap compared with the longer historical series — a period in which bond yields were generally much higher.
According to Nicholas Colas, co-founder of DataTrek Research. He doesn’t see a bottom until the S&P 500 hits 3,500, or a 27% drop from its January peak. The real number remains to be seen.