S&P Valuations: "Cheap"?

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S&P Valuations: "Cheap"?

The FactSet chart above of the last decade’s S&P 500’s price earnings ratios based on expected 12-month future earnings is making the rounds, so let’s talk about it. At first glance, it looks like US large caps are cheaper now (16.6x forward 12-month estimates, as noted) than the average of the last decade (16.9x, dotted blue line).

There are, however, three problems with using this chart as a “Buy” signal:

First, expected 12-month forward earnings estimates may be too high. FactSet’s math shows the Street is at $237/share for S&P 500 EPS over the next 4 quarters. If the index simply earns $55/quarter (its recent Q4/Q1 run rate) over the next 4 quarters, that’s only $220/share or a forward PE of 18.3x based on Friday’s close. This is still well above the 10-year average of 16.9x.

Second, it is hard to argue that stock valuations should be the same now as the average of the last 10 years. That’s because expected inflation, and therefore long-run interest rates, are higher now. The average inflation rate imbedded in 10-year Treasury Inflation Protected Securities (TIPS) from 2012 – 2019 was 1.95 percent. Now, it is 2.69 percent, and equity valuations should be lower as a result.

Lastly, the chart shows that once forward multiples start to decline precipitously (December 2018, March 2020) it takes a major shift in monetary and/or fiscal policy to see them recover. Why? Because markets want reassurance that policymakers stand ready to either avoid a recession (their fear back in December 2018) or stimulate the economy to bring it out of a downturn (March 2020). By contrast, policymakers today want to slow the US economy to curb inflation. That makes the current setup very different from past periods of “cheap” equity valuations.

Summing up: valuation is just a number, and the context around that number matters far more in assessing whether we’re truly “cheap”.