With the S&P 500 index now down roughly 18% from its peak reached about three month ago, for the first time in years it appears the U.S. stock market is severely oversold and pricing in worse than likely economic conditions. In the two weeks since my last post discussing valuation, the S&P trailing price-to-earnings ratio has dropped by more than a full point and now stands at just above 15x.
I have previously posted that we should expect P/E ratios of between 16x and 17x with the 10-year bond yielding in the 3-5% range (current yield: 2.75%). Given that 2018 corporate profits are pretty much in the books already, the current valuation of the S&P 500 assuming ~$157 of earnings is 15.3x (at 2,400 on the S&P 500).
Let's consider what this valuation implies. First, it presumes no further earnings gains, or put another way, 2018 is the peak of the cycle for profits. Could that be possible? Sure it could, but right now that is the base case. And even with that base case, stocks are 5-10% below the 16-17x P/E we would expect to see.
One could also make the argument that U.S. stocks are pricing in a mild, normal recession. Let's assume a typical 6-9 month recession occurs over the next 12-24 months, and as a result, S&P 500 profits drop 11% to $140. If a normalized P/E ratio would be 16-17x, I would guess stocks would fetch about 18x trough earnings during a recession (investors often pay higher multiples on depressed earnings). If we assign an 18x multiple on $140 of earnings, we get an S&P 500 target of 2,520, or 5% above current levels.
If we take a more bearish stance and assume a normalized P/E (16.5x at the midpoint, given low interest rates) on that $140 profit number, we would peg the S&P 500 at 2,310, or less than 4% below current levels.
I am not in the game of predicting short-term economic paths or stock market movements. All I can say now is that stock prices for the first time in many years are pricing in several of the most likely economic outcomes (normal recession or materially slowing GDP growth). Furthermore, it appears that the S&P 500 will close out 2018 at the lowest valuation since 2012.
Given those conditions, I am aggressively buying stocks with the majority of current cash balances in the accounts of those clients who are aiming for more aggressive, long-term, growth-oriented investment strategies. Put simply, I am seeing a ton of bargains right now and am not content waiting for further downside to pounce. For those who have excess cash on the sidelines, now could turn out to be a great time to add to your equity exposure, assuming that fits with your risk tolerance and investment goals.