Normalized P/E

In the wake of the 2020-21 mania, any dose of valuation sanity is obviously greeted with eye-rolls. We are going out of our way to present the numbers in the least-shocking way possible.

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We don’t know enough about banking-system mechanics to conclude if the Fed’s balance-sheet increase associated with March’s bank bailout constitutes a new round of QE. But if it is, we’re skeptical equity investors should celebrate it. In fact, those running Small-Cap portfolios should probably fear it!

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Stocks could trade higher in the next few months as CPI numbers enjoy easy year-to-year comparisons, prompting a more soothing tone in daily Fed-speak. Then again, the lagged impact of the last year’s rate hikes and balance-sheet shrinkage has yet to materialize, meaning we’re likely in the eye of the storm.

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Hopes that this decade might see a repeat of the “Roaring Twenties” took a hit last year. But there’s plenty of time to recover, and bulls will be encouraged to learn that cumulative stock market performance for this decade, thus far, is better than at the same point in the Roaring 1920s.  

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Some have speculated that 2022 might have been the kick-off for a decade-long era in which the broad stock market indexes will make essentially no progress, like 1966-1982. However, that earlier experience provided opportunities within other market segments, which will also stand a much better chance in coming years. 

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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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We’ve heard no references lately to the famous “Fed Model” for stock market valuation. We think we know why: The model’s usual proponents probably don’t like its current verdict—which is that stocks are far more expensive than at the early January market peak.

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We won’t dispute that investors were not genuinely frightened at the June market lows, or that fears have evaporated following a 13% rally in the S&P 500. The distress is understandable: For 26 traumatizing days in 2022, our S&P 500 Normalized P/E multiple traded below its 1957-to-date top decile!

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The sell-side is at it again, publishing a one-year ahead “Adjusted” EPS figure for the S&P 500 that is unlikely to be achieved—and then affixing P/E multiples seen near an historic market peak to “capitalize” on those unlikely earnings.

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Last spring and summer, we were incorrectly skeptical that a new bull had been born only five weeks after the death of oldest bull ever. But be careful with labels. Just as the “bear market” mindset caused us to overplay our hand last spring, equity bulls should not assume the current bull will look anything like the decade-long affairs we’ve seen twice in the last 30 years.

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The 2020 post-election stock surge looks and feels a lot like the 2016 “Trump Bump.” But, of course there’s a spoiler. The Biden Bump started with a Normalized P/E level about 30% higher than the one prevailing on election eve of 2016 (26.8x versus 20.5x, respectively). 

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The 2020 decline exhibits a strong resemblance to the “incomplete” bear market of March 2000-September 2001—in that neither decline sufficiently deflated the extreme valuations of the preceding bull, and each was followed by an immediate rebound in reliable valuation measures to top decile levels.

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July’s developments led to us investigate the market valuations accompanying all past month-end S&P 500 breakouts which (1) eclipsed the prior month-end bull market high; and (2) made a new all-time high in the process.

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Turn on financial television at any random time, and you’re likely to soon hear the argument that still-high U.S. stock market valuations are “justified” by extremely-low interest rates. We’ve countered that these low U.S. rates are simply a reflection of the secular slowdown in economic and earnings growth.

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Stocks (and more specifically, U.S. blue chips) did not fully (nor even approximately) discount the economic calamity. The result is that, in just over two months, the “baby bull”—if that’s what it is—has achieved what took his legendary predecessor more than eight years to accomplish: Top 25x on our Normalized P/E.

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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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Around the time of Donald Trump’s inauguration in January 2017, we observed that prevailing valuations argued against him witnessing big stock market gains during his first term.

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If the S&P 500 closes in the green today, an RSI "overbought" signal will be triggered.

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Small Caps typically underperform during a bull market’s final phase, and our findings with respect to the Output Gap aid our understanding of that phenomenon.

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With all the excitement over the Fed’s shift in rhetoric and the excellent subsequent market action, there’s a danger of losing sight of the broader cyclical backdrop for U.S. stocks. Remember, the economy is still operating beyond government estimates of its full-employment potential, and it’s not as if the Fed has actually eased policy—as it did successfully at a similar late-cycle juncture in the fall of 1998 and (ultimately unsuccessfully) in the summer of 2007.

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