Description

Is it Time to Buy Equities?

Although we are presenting this idea as a short, it may end up providing the foundation for you to go long instead.  The reason is because if the S&P has another 20% to drop, you may be thinking why don’t I start to dollar cost average into stocks? So depending on your time frame, you may take the other side of this idea.

Many recent articles in the financial press have been written around the common question, “is it time to buy equities?”  

In our opinion, we lack sufficient clarity on macroeconomic developments as well as the Fed’s expected course of action, and that the probability of a V-shaped recovery is low. Over the past decade or so, investors have become conditioned to simply “buy the dip”, but we believe that this year is different. It hasn’t been about what is already “priced in”, but about the regime change in monetary policy and the end of free money and the artificial repression of interest rates.

Donald Rumsfeld was notorious for his “known knowns and known unknowns” and as we analyze equity markets, we couldn’t agree more. We know that inflation has reached a 40-year high, and we know that the Fed is behind the curve but determined to contain it. What we don’t know is how far the Fed is willing to go and what they are willing to break in order to get there.

We strongly believe that current earnings estimates and P/E ratios remain too high, and the market still has downside risk. However, we also recognize that no one has a crystal ball, and that “they never ring a bell at the bottom.”  

We have analyzed decades of S&P 500 returns, earnings, and P/E multiple data that lead us to believe the equity market still has a way to go before reaching “the bottom”.  

Earnings Estimates are Too High

The impact of higher interest rates, inflation, and slowing global growth will increasingly feed into corporate earnings. At the beginning of the Q3 earnings season, 2022 consensus estimates for the S&P 500 are $223 and $242 for 2023, representing 8% expected growth. We remain skeptical of the Fed’s ability to engineer a soft landing for the U.S. economy, which makes 8% growth seem too high. We expect that earnings will be guided down through Q3 and Q4 earnings seasons. The unknown is by how much?

Peak-to-trough earnings revisions in previous pull backs range from -12% (Brexit) to -56% (GFC), with the dot.com bubble at -31%. Even if we assume a mild recession (earnings -10%), the 2023 estimate should be closer to ~$215, and a hard landing scenario would result in earnings closer to ~$200 (-20%).

What’s an Appropriate Price / Earnings Multiple in This Environment?

The P/E on the S&P 500 hit 23.0x in March 2021 after trading for nearly a decade above the long-term average (17.8x). Recent elevated P/E’s were skewed higher by the Fed’s suppression of interest rates and the impact of mega-tech multiples. JP Morgan recently calculated the top 10 S&P 500 equities trade at 24.7x and the remaining stocks in the index at 14.6x. As interest rates rise, growth slows, and investors find other attractive alternatives to equities, we believe the S&P 500 P/E could easily remain below its long-term average P/E multiple.

For context, in bear markets back to 1982, the S&P 500 bottoms at an average P/E of 13.2x

Have We Reached the Bottom?

As of Tuesday (10/24) the S&P 500 is -19% YTD, but the average of peak-to-trough pullbacks going back to the 1940s is -30%. We try to assess how the current environment compares to historical ones. For example, the 1980-1981 period saw a spike in interest rates while the 1999-2001 period was a valuation reset and growth slowdown in the aftermath of the tech bubble bursting. Today’s environment is unique, but if we use these periods as guideposts, there could be an additional 10% - 25% downside from here.

Market Bottoms are a Process, not an Event

Despite the abrupt sell-off and rebound that occurred in March-April 2020, historically market bottoms are a process, not an event. It takes time for investor expectations to reset around earnings, valuations, and expected returns.  We recognize the potential for sharp bear market rallies and increased volatility as more of the “unknowns” around inflation, interest rates, earnings, and economic growth become “knowns”, and we believe that these sharp rallies should be used for selling or lightening up until the markets get to a reasonable historical multiple.

Bear markets are merely a part of the process and they can be extremely unpleasant. It is incredibly difficult to pick bottoms to try to time the market. For example, an investor fortunate enough to have bought the market at the absolute low during the Great Financial Crisis (March 2009) would have enjoyed a 30% IRR for the next three years. But even an investor who implemented a year-long systematic dollar-cost-averaging strategy (see chart below depicting quarterly purchases beginning in August 2008) who began when the market was 25% off its high and bought both before and after the low, would have achieved an IRR of 17%.  

What Does All This Mean?

With the S&P 500 hovering around 3,800, it is trading at 15.8x the current 2023 consensus earnings estimate. However, if we assume 2023 earnings fall to ~$215, the P/E multiple would increase to 17.7x – about in line with the long-term average. Given interest rates have exploded higher and a variety of macro headwinds remain, we think ~15x-16x is a more reasonable P/E (but still above the low of 14.2x in March 2020). Applying that P/E to our lowered earnings forecast, creates a range of ~3,200 - ~3,600. However, if the economic scenario worsens into a more severe recession, then $200 in earnings and ~3,000 level for the S&P 500 is possible. 

The scenario analysis below shows where the S&P 500 can trade given different levels of earnings and P/E ratios.

Catalyst

Higher Interest Rates

Inflation

Lower Corporate Earnings