The Valuation Question

The following is an excerpt from our?Morning Briefing?dated?October 4, 2022.

The air continued to come out of valuation multiples last week, as inflation remains persistent and interest rates remain elevated.?

There’s an inverse correlation between the S&P 500’s P/E and the CPI inflation rate on a y/y basis (Fig. 1). We have quarterly data starting in 1936 for the P/E based on four-quarter trailing earnings and based on monthly forward earnings since January 1979. The CPI inflation rate is available monthly over this period. During periods of falling and low inflation, our composite P/E tends to rise and exceed its historical average of 15.0 (Fig. 2). During periods of rising and high inflation, the P/E tends to fall below its historical average.

On Friday, the forward P/E was 15.1, the lowest since April 1, 2020 but about at its historical average (Fig. 3).

The composite P/E is also inversely correlated with the 10-year bond yield based on data available since 1953 (Fig. 4). The correlation isn’t as tight as with the inflation rate. The S&P 500 forward P/E peaked last year at 22.7 on January 8. So its drop since then to 15.1 certainly can be explained by the jump in both inflation and interest rates since then.

The question is whether the P/E will hold at its historical average or fall below it. The answer depends on whether the US economy is heading into a hard-landing recession. If it is, then the forward earnings of the S&P 500 will fall along with both forward revenues and the profit margin. In this scenario, the forward P/E would likely fall below 15.0 on its way to the high single digits, as happened during previous recessions.

In our “growth recession” scenario, the PCED inflation rate continues to moderate from 6%-7% during H1-2022 to 4%-5% during H2-2022 and 3%-4% next year and the Fed hikes the federal funds rate two more times, by 75bps at the next FOMC meeting on November 1-2 and by 50bps at the following one on December 13-14. So the terminal federal funds rate range would be 4.25%-4.50%. The 10-year bond yield would peak around 4.00%-4.25%. In this scenario, the S&P 500 forward P/E would remain at or above 15.0, while both forward earnings and the S&P 500 price index would move sideways for a while before resuming their uptrends in 2023.

Our current subjective probability for this scenario is 60%. The odds of an inflationary boom are zero. So the remaining 40% is our subjective probability of a hard-landing recession.

Now let’s review the latest valuation metrics:

(1) MegaCaps, LargeCaps, and SMidCaps. At the end of last week, the forward P/Es of the S&P 500/400/600 fell to 15.1, 11.1 and 10.6. The latter two valuation multiples are back down to levels seen during past recessions. The spread between the S&P 500’s forward P/E and those of the SMidCaps (SmallCaps and LargeCaps collectively) has been 5.0 points since late last year (Fig. 5 and Fig. 6). That’s the highest since 2000.

The valuation multiple of the LargeCaps has been boosted by the forward P/E of the eight very high-capitalization stocks collectively dubbed the “MegaCap-8” (Fig. 7). The latter has also weighed on the former, as it has dropped from a record high of 38.5 on August 28, 2020 to 22.8 this past Friday. The MegaCap-8 has accounted for around 25% of the market cap of the S&P 500 since mid-2020 (Fig. 8). They accounted for 23.1% this past Friday, when the S&P 500 forward P/E was 15.1, or 13.8 without the MegaCap-8 (Fig. 9).

(2) MegaCaps, Growth, and Value. The MegaCap-8 has accounted for about 50% of the market cap of the S&P 500 Growth index for the past year. The latter’s forward P/E fell to 18.9 on Friday from 28.3 at the start of the year (Fig. 10). The S&P 500 Value’s forward P/E fell to 13.0 on Friday, the lowest since April 7, 2020.

(3) Foreign P/Es. Previously, we’ve observed that the forward P/E of the S&P 500 Value tends to closely track the comparable valuation multiple of the All Country World ex-US MSCI index (Fig. 11). The latter fell to 10.6 on Friday, the lowest since March 23, 2020. Here are the forward P/Es of some of the major MSCI indexes on Friday: US (15.6), Japan (11.6), EMU (10.2), Emerging Markets (10.1), and UK (8.7) (Fig. 12). All remain above their pandemic lows in early 2020, except for the UK’s 11-year low.

(4) Buffett ratios. The bottom line on valuations based on forward P/Es is that they seem reasonable, on balance, if the economy has a soft landing rather than a hard one. Of course, the valuation of the MegaCap-8 remains relatively rich.

On the other hand, Buffett ratios suggest that stocks remain somewhat overvalued. The ratio of the S&P 500 market cap to actual quarterly revenues, which peaked at a record 2.79 during Q3-2021, fell to 2.33 during Q2-2022 (Fig. 13). The comparable weekly series of the S&P 500 stock price index to the forward revenues of the index was down to 2.10 during the week of September 22. Both readings still exceed the 2.00 peak during the tech bubble in the late 1990s.

(5) Real yield. Another bearish valuation metric is the real earnings yield, which is S&P 500 reported earnings as a percent of the quarterly average S&P 500 index minus the CPI inflation rate (on a y/y basis using quarterly data based on three-month averages). It was solidly negative at -4.49% during Q2 (Fig. 14). In the past, it often bottomed near the end of bear markets.

(6) Dividend yield. During Q3-2022, the S&P 500 dividend yield was 1.82%. That’s well below the latest yield on three-month Treasury bills (3.46%), two-year Treasury notes (4.12%), and 10-year Treasury bonds (3.67%). If the dividend yield rose to match any of those levels, the stock market would be much lower (Fig. 15).

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