We hear a lot of market commentators refer to long-term average P/E multiples for the U.S. stock market when trying to assess what “fair value” might be. It is interesting to me that oftentimes the time periods they choose to focus on often map right on to the desired conclusion they want to numerically support.

For instance, the trailing 10 -year average P/E for the S&P 500 index is about 19.5. As a result, bullish Wall Street strategists can easily, and usually without much pushback, come on TV and pronounce the market cheap (at current prices - 3,735 - and current 2022 profit estimates - $224 - the market P/E is about 16.7x).

Of course, over the last 10 years we have had record-low interest rates that some thought would remain forever, but we are seeing that might not be the case. As an example, over the last 11 years, the 10-year U.S. treasury bond closed below 2% a whopping 5 times. Not likely we see a similar path over the next 11 years, with the 10-year pushing 3.5% today.

So if our goal should be matching historical data with current economic conditions, my attention turns to the period of 2002-2007, an 5-year run where the 10-year bond largely traded between 4 and 5 percent. What was the average market P/E ratio during that time? About 17 times. Using 2022 S&P profit estimates we arrive at a fair value of 3,800 - a mere 2% above current levels.

As we all know, in the near-term valuations overshoot to the downside and in recessions profits can take a quick one-year tumble. That dual uncertainty tells us that stocks could certainly go materially below that level for a few quarters without surprise. But over the intermediate to long term, even if higher interest rates persist, the overvaluation situation seems to have already largely corrected itself, as it always does.

The biggest question for me is where earnings go from here. Near term? Anyone’s guess. Longer term? History tells us not to bet against U.S. companies and their ability to grow profits over the economic cycle. Consider this: in the last 60 years the S&P 500 index has seen its cumulative earnings drop in back-to-back years just 4 times. As a result, investors who take a multi-year view rarely do poorly provided they don’t severely overpay for equities.

I know rates are most in focus right now, but I think the key to the next 12-24 months in the market will be how S&P earnings hold up relative to the all-time record $208 posted in 2021.