Don’t be fooled by stock market rallies—these are bull runs inside a bear market

On May 19, the S&P 500 hit a low for the year of 3901, marking a drop since the New Year’s Eve close of 18.1%. For the first time since the COVID-ravaged days of mid-2020, the big cap index’s P/E fell below 20 to 19.6, a big shrink versus its rich reading of 24 at the start of 2022. Apparently sensing that equities had re-entered bargain territory, folks and funds embarked on a mini-buying spree, sending the S&P up by nearly 6% in seven trading days, and erasing the big mid-month drop to finish May at precisely the 4132 level where it started. Among the famous, beaten-down names that rebounded were Neflix (+7.7%), Apple (+8.3%), Nvidia (+9.4%), and Amazon (+12.2%).

As I reported last week (How much lower will the S&P fall? A lot according to these metrics), just before the strongest leg in the rally, big cap stocks were substantially overpriced. The snapback does little to change that assessment. It’s simply a sign that we’ll see plenty of these sudden spikes, along with calls that we’ve reached a bottom, while the gravitational force of “reversion to the mean” that always dictates prices in the longer horizon inevitably take charge.

Given the resurgence in optimism, it’s worth reviewing numbers. Big cap stocks are still extremely expensive, and hence destined to either fall or deliver poor inflation-adjusted returns, for a basic reason: Corporate earnings mushroomed to bubble proportions via the spending frenzy that raged in the comeback from the pandemic. Now the balloon is leaking air as a parade of big names announce disappointing results and/or forecasts, among them Walmart, Target, Amazon, Netflix, Nvidia, and Snap.

Still, some investors, reassured by Wall Street’s buy-side analysts, are clinging to the view that last year’s gigantic earnings have more or less set a new, super-elevated base for the future. Hence they’re not slicing prices nearly enough to account for the sharp descent to much more stable earnings levels that’s already underway and set to gather speed. As we’ll see, today’s heavy inflation will do a much of the work in restoring both prices and earnings to levels where they have room to rise.

For investors trying to figure out a “fair value” for today’s S&P 500, and to estimate where the index is likely to settle in six months or a year, it’s crucial to determine when S&P earnings will reach a plateau that assures staying power. In this analysis, I use a few tried-and-true metrics to establish that number. The distance between the current S&P valuation and what the underlying fundamentals say it’s worth may shock you.

The earnings outlook

From the close of 2017 through the end of 2021, corporate profits enjoyed their biggest four-year rise—measured from an already reasonably high start—in more than a century. S&P 500 earnings per share jumped from $109.88 to $197.87, or 80%, (67% adjusted for inflation) garnering annualized gains of 17%. In the same roughly four year period, the U.S. economy expanded by 17.7%, meaning, in essence, that S&P 500 companies’ profits outpaced the production of goods and services they were selling by four and a half times. It’s notable that the 2021 EPS number was almost half-again higher than the record set in pre-COVID 2019, itself a banner year for earnings. In Q4 of last year, operating margins hit an incredible 13.4%, far above the median of around 9.5% over the past 11 years.

The just-published Fortune 500 ranking vividly illustrates the trend: For 2021, the members posted $1.8 trillion in earnings, a huge gain of over 50% in the total versus 2019.

Corporate America can’t conceivably maintain that super-sumptuous level of profitability. Earnings clearly need to reset, but where will they land? An excellent yardstick for determining a normal “reversion to the mean” level for earnings per share, a footing from which profits can reasonably grow in tandem with the economy, is the cyclically adjusted price/earnings ratio (CAPE) developed by Yale economist and Nobel laureate Robert Shiller. The CAPE measures whether stocks are cheap, expensive, or reasonably priced by using a five-year average of earnings per share, adjusted for inflation. That formula raises PEs when they’re artificially depressed by the kind of temporary earnings explosions we’ve seen recently (as well as accounting for unreliably inflated multiples when profits hit a short-lived slump).

At the end of May, the CAPE-smoothing formula puts 10-year earnings for the S&P 500, on average, at $128.43. That figure, however, requires an adjustment before it’s compared with today’s reported EPS. The CAPE marks up past profits to account for inflation, but not for “real” increases that exceed the trajectory for the Consumer Price Index. A rule of thumb used by a prominent investment firm that has strong academic grounding raises the Shiller number by about 10% to account for the “real” component. Taking the midpoint of 8.75%, the CAPE’s “sustainable” earnings come to around $141.

That figure is still 26% lower than the Q4 reading of $198. It implies that EPS was already a bit overheated when it notched an all-time high of $139 at the end of 2019, and was poised to flatten before the COVID economy launched the moonshot.

In 2021, the S&P 500’s earnings-per-share were so obviously inflated that even the almost-always overly optimistic Wall Street analysts are now predicting an annualized a decline in the annualized number for Q2.

2022 stock market predictions

At the end of 2017, just as profits took off, the S&P’s price-to-earnings multiple stood at 24.3. The next four years witnessed an amazing phenomenon: EPS jumped 90%, and the S&P increased by an almost identical amount. By New Year’s Eve of last year, the multiple had barely budged, to 24.1. Still, that would be a pretty high number, even if the numerator represented average rather than Brobdingnagian profits. The S&P’s median P/E since 1988 is 21.8, which in turn is well above the average of around 16 when the benchmark index is measured for more than a century.

At the market close of 4132 on May 31, the official P/E had fallen to 21, compressed by the year-to-date fall of over 13.3% for the S&P. That slightly below average multiple might make stocks look somewhat cheap. But once again, it’s swelled by a denominator of super-pumped profits.

We can arrive at a reasonable forecast of fair value for the S&P by deploying the Shiller earnings number (after our upward adjustment for “real” gains), and the average P/E over the past 33 years. A multiple of 21.8 applied to earnings per share of $141 would make the S&P reasonably priced at 3080. That’s 25% below its close of on May 31. The basics are clear: The S&P is still hovering over a big air pocket.

A markdown in EPS by nearly one-quarter, the top factor is establishing a fair value well below today’s levels, might seem extreme. But that’s not the case. At $141, earnings would still be 28%, or 6% a year, higher than they were at the end of 2017. At that starting point, operating margins were already elevated at 10.3%.

At a fair value of around 3100, the S&P would still stand close to its then-record following years of outsized gains at the end of 2019, and up 38% from the beginning of 2017.

A fall of 25% isn’t even particularly pessimistic. That scenario still projects that the market P/E will settle at almost 22, a high number by historic standards. It will only be that high if the markets continue to benefit from the extremely low real interest rates that have boosted PEs in the last decade. Multiples will also be far lower if the Federal Reserve fails in its campaign to quickly tame inflation. A fast-rising and volatile CPI vexes investors who fear the Fed will need to crack down even harder to tame raging prices, causing a severe recession. For comfort, they demand a super-fat “equity risk premium,” the extra expected returns on stocks versus risk-free bonds, as compensation for the rough ride ahead for equities. The risk-premium cushion only gets bigger when stocks get cheaper. Either persistently high inflation or a return to 2%-plus real rates would hammer multiples, making stocks dive much faster and steeper.

Once again, look for inflation to do much of the work in restoring valuations to levels that once again make equities a good deal. According to my calculations, if the CPI rises at an annualized rate of 7% for the next two years, and official dollar profits stay the same, stocks would still be overpriced by 10% in mid-2024 at the S&P’s current level. So it’s highly possible that to ring out all the excesses, we’ll be looking at earnings that go nowhere for the next two years, and an S&P that by mid-2024 falls to around 3720 to stand 10% below to today’s levels.

And we’re not even talking about a possible recession that would push corporate profits well below the already much-reduced number that’s reliable. One of the stock market’s few certainties is that its drivers eventually revert to the traditional norms and ratios, or close to them, governed by such forces as overall economic growth and competition that imposes a cap on profitability. Equities can thrive again. But the math shows that they’ll have to fall a long way from here before investors will get a genuine buying opportunity.