Downside

If uncertainty is the bane of investors everywhere, then the fear of large losses in a bear market is the boogeyman hiding in the closet. The threat of an agonizing downturn often leads investors to carry lower equity weights in their balanced portfolios than might be advisable, and even drives them to hold excess cash to avoid the risk of sizable declines.

ETF families have responded to this anxiety with a fund design that takes some downside risk off the table and may enable investors to tiptoe into equities even when they suspect a selloff might be around the corner. Known as “buffer”, “defined outcome”, or “target outcome” funds, these ETFs utilize an options collar overlay to trim the upside and downside tails of the underlying asset’s return distribution, thereby giving nervous investors a more comfortable way to pick up some equity exposure during riskier times.

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Thanks to the 2009-2021 experience, an entire generation of investors can’t distinguish between a stock market that’s down in price and one that’s actually “cheap.” The current bear market seems on course to make that distinction relevant again.

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The P/E multiple on Trailing Peak GAAP EPS has plunged 44% from its year-ago peak of 32.5x. The current ratio of 18.1x is below its “New Era” median (1995-to-date) —but some conditions characterizing the New Era no longer apply.

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How far might the S&P 500 fall in a recessionary bear market? The 2002 and 2020 stock market lows were both produced by “recessionary” bears; based on history back to the 1920s, those two lows stand out as the priciest bear market bottoms on record—and it’s not even close.

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We previously promised to limit the amount of comparisons to Y2K, but the paths that a number of the usual suspects are taking look more and more like “something we’ve seen before”—in some cases down to the percentage point.

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The 2022 economic backdrop is nothing like the near-Goldilocks environment accompanying the first few innings of the Y2K Tech bust. However, the action to-date in the former Growth stock leaders has followed the 2000-2002 path very closely—and almost on a point-for-point basis, when it comes to some  indexes. With the stock market “weight of the evidence” still negative, we wouldn’t be surprised if the Y2K analog holds for a while longer.

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Many investors will instinctively salivate at lower prices, whether or not they represent good value. Is there a better way to temper this Pavlovian impulse and improve results? We found it’s better to wait 25 days before re-entering the market after a 10%-correction threshold is breached.

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The concept of “mean reversion” used to help build massive fortunes. Of late, a better mantra has been “maximum attraction,” as valuations and bullish psychology have matched or surpassed excesses of the Y2K Tech bubble. Meanwhile, corporate profit margins, once dubbed “the most mean-reverting series in finance” by Jeremy Grantham, have now topped those seen near the Y2K top by more than 50%.

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Consider it a sign of the times: Here is the most bullishly slanted version of our “Estimating The Downside” exercise we’ve ever put in print (and likely ever will).

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We understand the various rationale for the upward shift in equity valuations seen over the last quarter century or so. Unfortunately, wiping away all market history prior to 1995 does not make stock valuations appear significantly less inflated. 

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If we assume that valuations will “bottom” at the “richest” levels ever seen at a bear market low, there’s still 32% downside remaining in the median S&P 500 stock.

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How does one value a stock market in which 12-month forward EPS estimates show their widest dispersion in history? A good start might be with methods we use when forward estimates show practically no dispersion (like three months ago). In either case, we place little weight on such estimates; each revision usually has only marginal impact on our 5-Year Normalized EPS.

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For those who must remain fully invested, an interesting (if not sickening) feature of the bear market is that those who entered it loaded with the most expensive and “trendiest” stocks and sectors have lost the least.

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With the markets in freefall, we’ve seen a dramatic spike in interest in our monthly “Estimating the Downside” vignette. We think a mid-month snapshot is in order to give some idea as to how much meat has been taken off the valuation bone.

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While our market disciplines remain negative, we certainly aren’t oblivious to the haircut in equity valuations that’s already occurred.

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While the consensus view remains that October’s stock market rout was “healthy” and “overdue,” we think it was  more likely the first leg down of much larger decline. But it’s still worth reviewing the improvement in valuations that market losses and this year’s excellent fundamentals have combined to produce.  

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We should emphasize that our characterization of stocks as dangerously overvalued applies only to the U.S. market.

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The longevity of this bull market is impacting tactical asset allocators in ways great and small.

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No, it’s not a 1990s-like love affair with the stock market. But it’s surely a sign of the times when TV pundits seem to have dropped even passing references to valuation when spinning their mostly bullish market yarns.

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Question: Your “Estimating The Downside” section shows the S&P 500 would lose 26% if it reverts to its 1957-to-date median valuation level. The downside estimate for the S&P Industrials Index, however, is almost -40%. Why such a huge difference?

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