Today was a bad one for US stocks and the close was especially troublesome, so let’s talk about what’s going on and what to do from here.
#1: Based on the macro inputs that have moved markets this year, this should not have been a down 2 percent day on the S&P 500. That’s a 2 standard deviation move – the sort of action that demands attention. Consider:
- March Fed Funds Futures prices rose today, and now imply 37 percent odds of a 50 basis point rate hike next month. Yesterday, those odds were higher, at 45 percent.
- 10-year Treasury yields fell slightly, to 1.96 percent, backing off yesterday’s intraday highs of 2.06 percent.
- The VIX only closed at 28.1, exactly 1 standard deviation from its long-run mean, despite a pronounced selloff in the S&P 500.
- Oil prices declined, with WTI down $0.40 to $91.35/barrel, despite heightened concerns about a Russian invasion of Ukraine.
Also on our radar tonight:
- The S&P 500 is only 1.2 percent away from its January 27th lows of 3 weeks ago.
- The NASDAQ has a little more breathing room, but not much: it is 2.7 percent away from its January 27th lows.
- The Russell is holding up a bit better, still 4.8 percent off its late January lows.
- The ARK Innovation ETF, our proxy for “speculative tech”, was trading after hours just 0.9 percent off its January lows. As Jessica outlined earlier this week, ARKK has been tracking closely to the NASDAQ’s experience from 2000 – 2002 and today’s price action fits that comparison. Worth noting: the NASDAQ had another year of declines from this point forward, so if ARKK follows the same pattern it is not yet safe to own.
- As for non-US stocks, the MSCI All-World ex-US equity index is 2.6 percent off its January 27th lows.
Takeaway: this setup of markets 1) swooning despite friendlier macro factors and 2) pushing their way back to recent lows says caution is still the best investment approach. You know our rule: never buy a new low. That’s usually just about 1-year lows (ARKK, for example), but we think it’s a solid thought just now about equities in general. Our work earlier in the week about how the VIX trended between 20 and 40 during the 2000 – 2002 bear market and only really pronounced highs (always over 30, sometimes even 40) illuminated useful entry points is top of mind tonight.
#2: Where is fair value on the S&P 500 based on historical earnings multiples? The FactSet chart below shows the last 10 years of forward price-earnings ratios. We’re certainly above the norms, at 19.5x versus 18.6x for the 5-year average and 16.7x for the 10-year mean valuation.
So, where does the S&P trade if we revert to these longer-run averages? Here’s the math:
- The Street is at $225/share for 2022. We’re a touch higher, at $240/share because we are more confident corporate margins will hold up well this year.
- Using this band of $225 – $240/share and the 5-year average PE of 18.6, we get an S&P range of 4,185 to 4,464. From today’s close of 4,380, that is a range of down 4 percent to up 2 percent.
- Using the same earnings band but the 10-year average PE of 16.7x, we get an S&P range of 3,758 to 4,008. From today’s close, that is a range of down 14 percent to down 8 percent.
The good news: based on 5-year trailing average PEs and either the Street or our earnings estimates, the S&P is within its fair value range right now.
The bad news: based on the 10-year average, the S&P needs to correct another 8 – 14 percent, to 3,767 – 4,030. The former is right where the index was in March 2021, and the latter is where it was in April 2021. Not that long ago, in other words, and all still well above the pre-pandemic highs of 3,380.
Takeaway: equity multiples are all about investor confidence in the predictability of future corporate cash flows and the interest/discount rates used to calculate their net present value. That’s it. Nothing else matters. On the earnings front, things are fine. On the interest rate side of things, not so much. Only 18 days until the March FOMC meeting, but we suspect it will feel a lot longer than that.