Is a stock market bottom near? Don’t count on it
Before I begin this article, do note the major disclaimer that I have got no magical crystal ball in front of me to accurately predict the direction of the market. This is just my personal opinion, supported by “cherry-picking” some market data, so do take it with a pinch of salt.
The market seems to be in “deep fear” territory, with the S&P 500 plunging by close to 4% on Monday, and the tech-heavy Nasdaq by almost 5%. The mantra now seems to be “sell first, think later”, as we witnessed stocks from all sectors being indiscriminately sold off.
The narratively this week is “all-eyes” on what the Fed’s action might. Following a higher-than-expected set of inflation numbers last Friday which set the “market roiling”, the Fed might now be forced to raise interest rates by 75 basis points (bp), instead of the initial widely-accepted 50bp rise.
How have things changed! It was not that long ago that the Fed was mooting “transitory” inflation, with Treasury Secretary, Janet Yellen, championing that notion back then, but now changing her tune to say that inflation is likely to stay high.
She tops that off by saying that there is nothing to suggest that the US is entering into a recession.
According to the CNBC CFO survey, based on a pool of 22 C-suite management views, not a single CFO surveyed by CNBC thinks that a recession can be avoided.
So, it is Janet Yellen vs. Top corporate CFOs. I will put my money on the latter but that is just me.
Rising interest rates fuelled by inflation
While I do not claim to have a magical crystal ball in front of me, I did highlight on multiple occasions as early as 2020 that the risk to the stock market starts with the possibility of inflation running rampant. This will force the Fed to involuntarily raise interest rates despite their every intention to “keep the drugs pumping”.
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With inflation running hot, there are no other alternatives but to raise interest rates, possibly on the “pretense” that the economy has recovered well post COVID-19 and growth is in “gang-buster” mode.
What growth? We are now talking about the possibility of a recession, which according to top corporates’ CFOs, seem imminent, contrary to Ms. Janet’s view. If inflation remains a “hot issue”, then for the very first time since the 1970s, the world will be facing the dreaded consequence of both negative growth and high inflation, or what one term as STAGFLATION.
Again, not the first time that I have brought up this risk to my readers, with a recently updated article on how one can better position his/her portfolio when the “stagflation bull” takes charge.
The big question now is: Has the market already priced in a recessionary scenario?
Scenario Analysis: where might we be?
With the close to 4% collapse in the S&P 500 index a couple of evenings back, the S&P 500 is now in “bear market territory” as characterized by a 20% decline from its peak.
This might seem significant. But has the market already factored in a “base case” scenario of a recession?
Here are my different scenarios
Bull Case: the US avoids recession and corporate earnings remain robust. Inflation moderates.
Base Case: the US enters into a recession with corporate earnings being reduced. Inflation moderates.
Bear Case: the US enters into a recession with corporate earnings being slashed. Inflation remains “sky-high”
According to DataTrek, the current earnings of the S&P 500 are pegged at $218/share. The chart below, derived from multpl.com, shows the historical S&P 500 EPS, stretching back from the 1870s to the last reported record in 2021.
Assuming that the current $218/share estimate for 2022 is accurate, with S&P 500 trading at $3,750, that will translate to a forward PER multiple of 17.2x, which seems pretty reasonable, at first glance of course.
Using data from the same website, the chart below shows the historical PER multiple of the S&P 500. The trailing multiple now stands at 19x (using the 2021 EPS figure). While that figure has dropped from a recent high of 35x, it is still on the “high-end” based on 15 decades of historical data, with the long-term average likely to be closer to the 15x region.
The argument for multiple expansions is that we have been in a low interest-rate environment for a long time and that help supports stock market valuation. That scenario, however, is changing. Should our expectations now be moderated back to “the norm”?
Fair value PER multiple
While we have been pretty used to having a fair value PER multiple of c.25x in a low-interest-rate environment, that should now be moderated down to 15-20x in a rising interest rate environment, in my view.
Based on our Bull Case Scenario where we expect EPS to be at $218/share, the fair value of the S&P 500 could range between $3,270 to $4,360. With the price currently at $3,750, it seems like we are still “priming for a Bull Case”. Despite how “terrible” the market seems to be at present, it is not yet all doom and gloom, in all practicality.
Now, according to DataTrek, in a “standard recession”, the EPS typically falls by 26% from peak to trough, with the Great Recession back in 2009 translating to a 57% peak-to-trough decline.
So, in a standard recession, which is my base case scenario, EPS will decline from $218 to $161. Using a similar forward PER multiple ranges of 15-20x, we now have a targeted S&P 500 price range of $2,415 – $3,220
In the event of a Bear Case Scenario where we witness stagflation, one which has not happened since the 1970s where interest rates then were “forced” to rise substantially more than 10% to curb inflationary pressure, there is a possibility, however remote or “unthinkable” that scenario might be, for the S&P 500 to decline lower than $2,415.
That will imply that the S&P 500 will have declined by more than 50% from its recent peak level of $4,818. Well, at least this doesn’t seem too remote for a relatively well-known bear by the name of Mr. Jeremy Grantham, who forecast that the S&P 500 could decline by approx. 40-60% from peak to trough.
Conclusion
Once again, a disclaimer that I don’t own a magical crystal ball over here. But I believe that we might not yet have seen the worst.
My reason is that we have yet to witness a round of earnings downgrade by the street. If a recession is upon us, then I believe that a record $218/share EPS in 2022 is a tad too bullish. While a recession might not yet be evident in 2022, with the consensus that it will happen in 1H23, the market is likely “forward-looking” and would have priced that in by 2H22.
Or perhaps when Janet Yellen finally admits that the US will be heading into a recession.
Assuming we now have to settle for a regime where the interest rate environment “reverts” back to the long-term norm of 3% (we have been in a low to zero-interest-rate environment for so long that it seems to be the norm), one should also expect the valuation multiple to moderate back to the norm of between 15-20x.
Again assuming (yes long-term investing is all about assumptions made) that we exit a quick recession and the S&P 500 EPS trends up to a level of 231 (6% growth rate from current $218 expectations) in 2023/24, the fair value of the S&P 500 based on a valuation multiple of 15-20x will translate to $3,465 – $4,620.
While I might be wrong in my attempt to “predict” where the S&P 500 might be in the foreseeable future, this is me looking to rationalize my view based on certain assumptions that I have made.
You might or might not agree with me.
Bottom line: I don’t think we have yet seen the bottom in the S&P 500. While there could be plenty of dead cat bounces along the way down, we might be potentially closer to the bottom if the index price starts with the number 2 and not a 3, as of where we are right now.
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