It is a healthy time to be asking whether stocks are expensive or cheap. I say that because of the huge drop through the first three quarters of 2022 followed by the subsequent healthy rebound ever since. Did stocks get too cheap in the selloff? Have they returned to fair value? We will get to those answers, but the short answer is that it really depends on what the inquisitor means by “stocks”. That is always the case (i.e., different pockets of the stock market are in favor at various times), but the phenomenon today is particularly acute.
Each investment environment is unique and one of the ways I’d characterize this period as unique is the progression of valuation in this market. One would have expected a more severe correction and “cheapness” in stock valuations given the severity of the price decline, but instead the healthy premiums to own stocks have endured. Yes, the bear took out some excesses and knocked down the substantial premium stocks were carrying through ’20 & ’21. Specifically, the forward PE ratio (which is simply the price at any given moment for the underlying earnings) on the S&P 500 has a long term average of 14-16 (depending on the period) but held firmly above 20 for 2020 and 2021; levels only seen during the dot com boom.
At this point, the valuation adjustment appears much more like a partial mean reversion than the typical shakeout that ends up overshooting into a trough.
Decomposing market returns
The starting point in answering the question as to whether stocks are expensive or cheap entails a decomposition of how the S&P 500 went from point A to point B. We never fully know why price levels are where they are, but we can X-ray into the S&P which can in turn, more fully illuminate our current situation. The movement in the S&P price from any point A to any point B can be broken down into these explanatory components:
1) Earnings expectations rising (or falling)
2) Changes in the PE; changes which can stem from one of two primary drivers:
a) changes in interest rates
b) changes in risk taking preferences (the net composition of all investor concerns)
If S&P 500 earnings are 200 and the level is 4,000, then the multiple is 20. If earnings rise to 220 and the 20 multiple is held, the level goes to 4,400. Calculating these figures and studying this relationship helps shed light on the character of the advance and whether investors are swinging too far on either end of the optimistic or pessimistic end of the pendulum.
The S&P 500, at 4,137 at the time of this writing, is down 13.2% from its start of 2022 after briefly being down as much as 25% in late 2022. At the start of 2022, analysts collectively were expecting approximately $230 in earnings per S&P 500 unit over the following 12 months. The going forward expectation here in late April ’23 is for earnings of $227 (Factset data), or little changed during the time of the 13.2% drop. If earnings are unchanged, then the PE ratio is left as the sole driver of the 13.2% decline, observed by the fall in the ratio from a forward PE of ~22+ to ~19.
Higher rates or Lower risk tolerances?
To answer the question of whether it’s 2a or 2b from above, we can use some mathematical relationships to test whether it’s the rate or risk influencing the PE change. In this case, we really don’t need fancy regression math to understand the driver behind that PE drop is interest rates or one of the two main drivers of changes in PE levels (but yes, that fancy math does indeed affirm this). The breakneck pace of interest rate increases has introduced a host of low risk choices to compete with stocks for investment dollars. Money markets going from 0% to 4% gave equity markets little choice but to get cheaper.
Tagging higher rates and not rising safety preferences by investors as the culprit is corroborated by the relative sanguineness observed in credit spreads. Credit spreads tell us how much additional interest investors requires to invest in its basket of riskier corporate bonds in lieu of US treasuries and can be measured by the US High Yield Master II OAS index measures. That spread is higher than the rock bottom levels found in early 2022, but at 4.47% is right at its 10 year average of 4.48%. If the PE hit were more due changes in risk preferences, we would expect to have seen some more fireworks here.
Where earnings go from here is anyone’s guess and will depend on how the economic cycle takes shape (do we continue slugging out positive GDP quarters or do we have a recession?). According to Bloomberg, the average earnings decline during a recession 16%. So, if a recession does take shape, earnings could take the baton from valuation as the driver to S&P 500 price adjustments. But a recession isn’t set in stone and the odds of whether we do or not is a topic for a different day. The focus from here is on what we do know, which is that stocks are priced at a 15% or so premium to their long term averages (18x now vs. 15 avg).
Look Deeper
However, there is more to the story. An important part of the story that looks deeper across the 11 sectors that comprise the index. It is not that all sectors are on the expensive side, the technology and consumer discretionary sectors are carrying the entire S&P 500 premium. Keep in mind that the sectors are not equally weighted. In fact, the tech sector is larger than the basic materials, utilities, energy, consumer defensive and real estate sectors combined!
So, when you combine the relative size of the tech and discretionary sectors with how expensive they remain, it tells us that most of the S&P 500 is closer to fairly priced rather than expensive. An equal weighted approach remains compelling compared to a capitalization weighted one.
To be clear, valuation data like this is not predictive or useful in any near term tactical ways. It can, however, assist in repositioning portfolios towards better risk and potential reward combinations. The S&P 500 being expensive should not lead to a prediction that a price decline is imminent; it just means probabilistically that appreciation from here will need to lean more heavily on earnings growth. A healthy optimistic outlook is potential relative upside in the other 9 sectors if their valuation levels were to gravitate towards the tech and discretionary duo. in the sectors that could return to the premiums held on to by the tech sector. Or, conversely, be more of a protective floatation device if tech and discretionary continue the long and winding road to their average that began early last year.