The S&P 500 Looks Cheap, But Don’t Get Burned By High Valuations

April 27, 2020 1:53 PM UTC
Investors might be attracted by a lower S&P 500, but they could get burned by high valuations if they jump in now.
  • The S&P 500’s depressed level masks high valuations.
  • The Fed’s actions have created false hope ahead of a bear market.
  • Warren Buffett remains on the sidelines.

The S&P 500 has plunged amid the coronavirus lockdown, but high valuations could burn investors.

Even after a strong rally, the S&P 500 is well off its peak this year–a tempting proposition for investors who think they might be getting a good deal.

But with stocks hitting 21x their expected earnings, investors are going all-in on a sharp economic recovery.

The S&P 500 Index is now more expensive than both the five- and ten-year average. | Source: LinkedIn

Predicting Earnings Has Never Been Harder

Nobody can predict the future, especially now.

Bosses often make educated guesses about trading conditions in the coming quarter or 12 months. But coronavirus has changed that, with many firms pulling guidance altogether.

It is entirely unclear how consumers will react when lockdown has lifted, how many people will get their jobs back, and what household incomes will look like.

That didn’t stop investors pushing the S&P 500 to dotcom boom valuations, clearly reflecting a view that the Fed can make markets rise no matter what.

Investors are paying high prices for stocks despite the dire economic outlook. Source: Financial Times

Emmanuel Ferry, chief investment officer at Banque Paris Bertrand, said at 2,836 points, the S&P 500 is now more expensive than at the bull market peak in February:

Investors may be right with their optimism paying 19x if there is a sharp rebound in activity, validating a V-shaped pattern for EPS. If not, the policy-driven rerating will be a bull trap and markets will soon retest new lows.

Bears Are Roaring Louder

Optimists and pessimists constantly tussle about how long a market trend will last.

But bearish investors see the Fed’s unprecedented stimulus packages as a temporary shot in the arm.

Some investors think stimulus-driven valuations are simply a trap. | Source: Twitter

Traders scrutinizing the data suggest even at a “generous” 15x forward earnings, with corporate income staying flat, the index will fall to 2,100–a 25% drop from current levels.

If the earnings multiple drops to 12.5, which is still above the median for the past nine recessions, and earnings drop slightly, the index will hit 1,500.

Positive Forces Snuffed Out

Beyond earnings, the market is being driven by several other key factors.

A major one of these is buybacks, which, according to Barrons, are responsible for 20% of S&P earnings growth in recent years.

Federal bailouts could make company buybacks controversial at best or, at worst, be banned for those receiving taxpayer cash.

The massive $2 trillion stimulus package launched by Fed chair Jerome Powell is fuelling confidence in the stock market. | Source: NICHOLAS KAMM / AFP

And with an astonishing 26.5 million Americans losing their jobs in a matter of weeks, pension contributions are likely to suffer.

Many U.S. workers buy index-weighted ETFs, whose massive inflows in recent years have pushed markets–and valuations–higher.

But furloughed workers are unlikely to contribute to their pensions and may even draw from them earlier than planned. This could hit stocks too.

Nothing Is Cheap, as Buffett’s Growing Cash Pile Suggests

A worrying aspect of the S&P 500 now is that even so-called ‘cheap’ value stocks don’t live up to their name.

It is, therefore, unsurprising that the world’s most famed investor, Warren Buffett, is adding to his vast $128 billion cash pile rather than invest.

Even ‘cheap’ value stocks (the bottom line) could be considered expensive at these valuation levels. | Source: Anothervalueblog

Value investor Guy Davis says not only are ‘expensive’ growth stocks overvalued relative to their history, but value ones are too:

This is not yet a situation like 1999, where value stocks were cheap on an absolute and relative basis, and would actually go on to rise as the broader market lost over half its value.

All this suggests investors should be wary of market bounces that indicate a recovery is already here.

As Ferry said:

The current market cycle is not a 100m sprint but a marathon. The quick fix released by policy-makers is just the first episode of a long-lasting bear market.

 

Disclaimer: The opinions expressed in this article reflect the author’s opinion and should not be considered investment advice from CCN.com. The author holds no investment position in the assets mentioned above.

Sam Bourgi edited this article for CCN.com. If you see a breach of our Code of Ethics or find a factual, spelling, or grammar error, please contact us.

Last modified: April 27, 2020 1:54 PM UTC

@BradleyGerrard

Bradley is a freelance journalist with experience in covering finance, investment, transport, and leisure for national newspapers including The Daily Telegraph and the Financial Times Group. Reach me at bgerrard63[at]gmail.com. Bradley Gerrard is a Trusted Journalist. Visit my MuckRack profile here.