By Jurrien Timmer, Fidelity
1. Stocks appear somewhat overvalued compared with interest rates, in my opinion, and may have additional declines ahead of them.
2. That said, the US economy still seems to be in an expansion — albeit a slowing one — based on earnings and economic indicators.
3. The closest historical analogy we may have to the current period is the 1940s. That analogy suggests investors may need to be patient in waiting for the market to make up its lost ground.
After a rocky past couple of weeks in the markets, let’s take a step back to get some perspective on the bear market, this Fed cycle, and the strength of the economy.
Currently, there are some potentially bad, good, and mixed signals to interpret. Let’s dig in.
The bad: The market may have further to fall
The S&P 500 is now trading at 16.5 times expected earnings. Even after giving up much of their summer rally, stocks appear somewhat overvalued given the movements we’ve seen in interest rates.
Exactly how overvalued they are (and exactly how much further they may need to fall in order to approach fair value), may depend on which interest rate measure one uses.
According to my calculations, based on the 2-year yield, the fair value for the S&P 500 ought to be about 13.5 times expected earnings, or 3,159 (implying a more than 15% potential decline from recent levels). Based on the 10-year real interest rate implied in yields for TIPS (Treasury Inflation-Protected Securities), the fair value may be a bit closer, and the potential drop less painful.
Perhaps a better approach is to combine both yield indicators into a single model. When I did so, I came up with a fair value for the S&P of 15.1 times expected earnings, which is about 3,531. That level would be about 9% below last week’s close, and slightly below the lows struck last June.
Of course, that figure depends on earnings holding up. If earnings estimates prove to have been too optimistic, then that fair value would be lower.
The good: A soft landing may still be within reach
From what I can tell, the US economy remains in an expansion. I have been traveling up a storm lately, and every flight continues to be full.
Economic indicators and earnings continue to show an economy that is still expanding — just at a slowing pace. For example, the Fed’s weekly economic index is a composite of weekly economic indicators, and shows how many of those indicators are rising or falling. Currently, the index is falling but remains above zero, implying an expanding (but slowing) economy.
Similarly, earnings estimates have continued to hold up so far, but analysts are now starting to revise their estimates lower.
The consensus estimated earnings-growth rate for calendar year 2022 has remained steady at 9.9%. However, if one excludes the energy sector, that estimate falls to 3% and has been declining. Third-quarter earnings season is still a month away, but so far, the earnings-growth estimate has been holding steady at about 4%.
Another measure to consider is the breadth of earnings estimate revisions — which can indicate whether declining expectations are impacting a more widespread or more limited part of the economy.
Out of the 24 industry groups in the S&P, only a third are seeing positive earnings revisions. In recessionary bear markets, that figure has typically dropped to zero (meaning all industry groups experience negative earnings revisions). So for now, the weakness is still consistent with a soft landing.
The bottom line: Investors must be patient
As I have written about before, I continue to believe the current period has some notable parallels to the post-WWII bear market of 1946.
While the circumstances of today are very different from the 1940s in many ways, there are similarities too. Back in 1946, after the war ended and the veterans came home, the economy had to transition from wartime to peacetime.
This created supply-chain bottlenecks and very high inflation. The S&P 500 suffered a 26% decline, entirely driven by falling price-earnings ratios (rather than by a recession and falling earnings). Earnings never missed a beat, at least in nominal terms.
Interestingly, if the market were to eventually hit a new low of about 3,500 (as my fair-value calculations have suggested), it would equate to a drawdown of about 27% — almost exactly in line with the 1946 post-WWII analog.
If we continue to follow that analog, where might we go from here? After 1946, it took 3 years of sideways trading before the market finally made a new high. I’m not suggesting that it will take as long for this correction to end, but I do think that this cycle will require some patience. For now, the next 10% move for equities remains down in my view.
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