The next leg of the bear market could be here, as investors begin to turn their attention away from the Fed to a significant deceleration in earnings as valuations head higher. Relative to bonds, stocks haven’t been this expensive in more than a decade, which should make investors take a step back and look at what they are paying for.
The S&P 500 (SP500) is currently trading for around 18 times 2023 earnings estimates of $224.68. While that may sound cheap, it is not cheap over the long run; it is just that investors have gotten used to the bloated valuation witnessed during the pandemic bubble. It is especially true as earnings estimate steadily decline for 2023 and the projected growth is melting away.
More interesting is that roughly 18 times earnings have served as a top in the S&P 500 during the August and December peaks. Historically, the only times that the index traded above 18 times forward earnings were from 1997 until 2001 and late 2019 until the winter of 2022, which were undoubtedly bubble periods.
Relatively Over Valued
Even when comparing the S&P 500 to interest rates, the S&P 500 is not cheap, with an earnings yield for 2023 of around 5.7% versus a 10-year rate of about 3.45%. That creates a spread of approximately 2.25%, the narrowest spread between the two since 2007. It tells us that S&P 500 is expensive versus the 10-year rate.
So, not only are stocks expensive on an absolute basis and when evaluating the S&P 500 versus the 10-year rate, but it is also expensive when considering the index is expected to grow earnings by just 3% in 2023, as earnings and profit margins are revised lower.
Below Trend Growth
On top of that, mounting evidence suggests that earnings estimates are likely to head lower as the economy continues to slow to below-trend growth rates as the Fed is targeting. The US Leading Indicators, over time, have had a strong relationship with trends in earnings growth rates. Currently, the LEI is down by 7.4% on a year-over-year basis and has been steadily trending lower since peaking in the summer of 2021.
Additionally, there is a similar relationship when using the ISM manufacturing index. This also tells us that the economy is slowing, and year-over-year earnings growth tends to follow the ISM trends over time.
When breaking this market down, it is overvalued on many levels, making it hard for the index to continue to push higher from here. It is probably why the index has stopped rising on the two prior occasions around 18 times and is struggling to move higher on this most recent test of that PE ratio.
The bulls need to ask themselves how much they are willing to pay for earnings on an index that will have virtually no earnings growth in 2023 and is trading with its tightest premium to the 10-year rate in 15 years as there remains a great deal of uncertainty around the path of monetary policy and the overall direction of inflation.
Editor’s Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.