Equity prices have declined significantly and are now back to or near late 2020 price levels.
This has many investors seeing this as an opportunity to buy the market at a discount.
Valuation and Subsequent Returns
- Buying the market at a lower price multiple has historically been a solid method by which to amplify long-term returns
- In the short-term, returns have a weak relationship with the forward price-to-earnings ratio. Over a longer period, the correlation between the forward price-to-earnings ratio upon investment and subsequent returns is well correlated.
Is the market a "deal" now after the steep decline in the first half of 2022?
- After the significant decline in price over the last 6 months, it may appear that the market is now a 'bargain'. The forward P/E (10-yr average 2009 – 2019 Price/Earnings Ratio) of the S&P 500 at a price of $4000 and EPS (Earnings Per Share) of $237.18 is 16.9. This is below the 5-year average (18) and equal to the 10-year average (16.90).
- However, the 5 and 10-year averages are heavily skewed by the pandemic surge in forward multiples which rose to over 23 in the back half of 2020 as investors, flush with stimulus cash and backed by historically accommodative monetary policy, bid up stock prices to historic levels.
- If we consider the 10-year period preceding the recent price distortions of the pandemic period, we see that the 10-year average forward P/E is 14.9.
- Historically, the best 'bargains' occur in recessions. At the depths of the Great Financial Crisis, forward P/E plummeted to the single digits.
- Assuming forward earnings estimates are accurate, the S&P 500 at a forward P/E of 14.9 would imply a price target of 3,534, and -11.7% decline from 4000.
- The assumption that earnings estimates will deliver is one with a weak historical track record. According to Ned Davis Research, since 1984, consensus estimates for S&P 500 operating earnings have proven to be 8.2% points too high one year ahead.
- Note that in periods of economic weakness (Savings & Loan Crisis, DotCom Bubble, Great Financial Crisis, Taper Tantrum, Covid) earnings are revised downward at least -15% and as much as nearly -60%.
- If earnings estimates are revised downward by the historical average of -8.2%, at a 14.9 forward P/E, this implies a price target of 3244, an -18.9% decline from 4000. If earnings estimates are revised downward by the minimum historical average coinciding with economic weakness (-15%), this implies a price target of 3004, a -24.9% decline from 4000.
Conclusion
Will a market decline of this magnitude come to pass? Not if earnings prove to be resilient in the face of the many macroeconomic headwinds we currently face. If, however, earnings are revised downward to any significant degree, current pricing is still rich, even after the recent decline.