Tempted by the cheap valuations the equity rout has produced? Think again: stocks may still be much more expensive than they seem.
The ratio of price to estimated earnings for the S&P 500 Index has fallen to 15.5 times, much lower than the dotcom era’s 25.7 and almost the same as at the start of the bull market. Emerging-market stocks are similar: the benchmark gauge has fallen below its life-time average valuation and is also 30% cheaper than its all-time high.
But stock prices discount known risks more quickly than analysts’ estimates for earnings, which follow with a time lag. Indexes already reflect the latest reality, but profit forecasts don’t yet. That means the current price-to-earnings ratios are logical fallacies.
In 2000, the S&P 500 peaked in March but profit projections kept going up until September. The delay was shorter in 2007, at 20 days, but sustained cuts to forecasts didn’t begin until June 2008. For emerging markets, the lag was nine months in 2007-2008, 12 weeks in 2011, and three months in 2018.
So, when stocks are falling but earnings-per-share estimates are yet to catch up, how do you evaluate the true worth of stocks?
There may not be a foolproof method, but leaning on history is a sound proxy. We can estimate the extent by which analysts cut forecasts on an index during a significant rout driven by economic crises, and use that to calculate how low stocks must fall to reflect their average valuation. That would give investors a sense of how long they should wait before buying the dip.
In the slump that followed the bursting of the dotcom bubble 20 years ago, the U.S. benchmark witnessed a reduction of 14.3% to its EPS estimates. The 2008 financial crisis prompted a 39% cut.
Let’s take the smaller of the two cuts and assume analysts will prune their projections by the same degree this time round, especially because expectations for a recession are building up just as they were in 2000.
That would mean the average EPS estimate could go down from a peak of 178.54 points to 152.97 points. The average price-to-estimated earnings ratio for the index, based on available data for 30 years, is 15.84. That implies a target price of about 2,423, or 12% lower than Wednesday’s close, and suggests a potential buy-the-dip point.
The current price, expressed as a multiple of the lower assumed EPS, shows a hypothetical valuation of 17.9 times, a seventh higher than the apparent valuation. That’s how costly U.S. stock markets are now.