One thing to realize about a stock selloff: You won’t know it’s over until long after it ends. But that doesn’t keep people from trying to pick a bottom. Valuation, sentiment and history each form a basis for study.
Reversion to a mean is the expectation. Which mean to revert to is the problem. A straightforward model in which elevated valuations return to normal could imply either a garden-variety tumble, or a truly awful one, depending on how “normal” is defined. If a purging of animal spirits among overenthusiastic bulls is how you pick the floor, a case can be made that we’re not quite there.
“Having a framework for times of uncertainty is imperative,” said Chad Morganlander, senior portfolio manager at Washington Crossing Advisors. “Not having a proper risk protocol or risk framework is equivalent to not having a carbon monoxide detector or fire detector in your house. Or driving drunk in a Ferrari blindfolded.”
Following are a few models for considering where the market might ultimately land.
Valuation
First the good news. With its 17% decline this year, the S&P 500 now sits in line with the recent average when measured by the price of its constituents divided by their overall earnings. Using the mean P/E multiple going back three decades -- a period generously distorted by the dot-com bubble but which also reflects what many consider a modernized view of valuations in the era of buybacks and intangible assets -- the benchmark’s ratio is 19.5, slightly below the historic average of 20.3.
A less-optimistic methodology elongates the historical series, generating a significantly lower average valuation for the market, which requires a bigger decline for things to normalize. Among the most pessimistic frameworks is Robert Shiller’s cyclically adjusted price-earnings (CAPE) model, going back more than a century and smoothing the ratio out over 10-year intervals. Using that, the S&P 500 would need to plunge by a hair-raising 47% to wring out its excesses.
A third lens considers what might happen should the retreat cascade into a bear market. The S&P 500 has already fallen 18% from its January high, approaching a bear market, or a drop of at least 20% from a peak.
The bear-market scenario introduces an element of cheating, because it effectively says “if things get worse, they will be worse,” though it nevertheless provides context. Since World War II, stocks in a full-blown bear plunge stopped falling when the P/E ratio hit 12.6, on average. Following the same blueprint would mean another 35% drop for the S&P 500.
Fed Model
A big bull case for equities for the past decade is the argument that with bond yields stuck near record lows, stocks are the only place to be given corporate profits keep growing. That narrative has been challenged this year with the Federal Reserve embarking on a rate-hiking cycle to combat inflation.
One approach that plots the relationship between bond yields and corporate earnings is something known as the Fed Model. While not universally accepted, the technique offers a window into the always-shifting bond-equity link that may provide clues on the fate of stocks in a new high-rate regime.
In the simplest form, the Fed model compares 10-year Treasury yields and the earnings yield for the S&P 500, a reciprocal of P/E that measures how much companies are generating in the form of cash flow relative to share prices. Right now, while the edge for equities is shrinking, with bond yields at one point spiking above 3% for the first time since 2018, it still offers decent buffer, at least relative to history.
As things stand now, the picture shows stocks as still moderately expensive relative to the history of the post-crisis bull market, but quite cheap compared with the longer historical series -- a period in which bond yields were generally much higher.