The Tides Have Turned As Stocks Continue To Sink
Summary
- The S&P 500 is breaking key level of technical support.
- Typically, when the market's technicals break, we turn to fundamentals.
- The problem - stocks need to fall as much as 15% more to find fair value.
The S&P 500 has fallen about 10% from its peak at the start of September, as the Nasdaq 100 has lost about 13.5%. But these losses are likely to grow worse, as valuations are still very high for the S&P 500. Based on valuation, the S&P 500 could even fall by as much as 14%. From a technical standpoint, the S&P 500 could have as much as 13% further downside risk.
The most significant risk to this market is that the technicals are breaking down. Typically, when we start seeing market technicals break down, we look to fundamentals for support. The problem here is that the markets have no fundamentals to support them during this breakdown, given the vast gap that exists between the current levels in the index and what could be considered fair value for the S&P 500 with a PE ratio approaching something in the 16 to 17 times earnings range.
Earnings Do Not Support The S&P 500
Based on my proprietary model, some of the earnings metrics of the S&P 500 have been slowing and have now started to reverse lower recently. Additionally, the S&P 500 is hugely overvalued when adjusting for long-term earnings growth expectations. They are still at their highest levels in about 40 years.
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Currently, the MCM Reading The Markets earnings model estimates 2020 earnings for the S&P 500 of about $125.00. Followed by a growth rate of almost 27% in 2021 to $159.40 and 17% in 2022 to $186.50. Assuming a fair value P/E multiple of about 17 times 2021 earnings estimates, the S&P 500 is worth about 2,700; using a 15 multiple on 2022 earnings estimates, we get a valuation of about 2,800 on the S&P 500.
SPX | 3,235.77 | PE Ratio | Growth Rate | Forecast | Growth Rate |
2020 | $ 124.86 | 25.91 | |||
2021 | $ 158.44 | 20.42 | 26.89% | 2,693.43 | -16.76% |
2022 | $ 185.36 | 17.46 | 16.99% | 2,780.38 | -14.07% |
(MCM Reading The Markets, using bottom-up mean analyst earnings estimates)
When we look at the S&P 500, adjusting for long-term earnings growth, the index is hugely overvalued. Currently, long-term earnings growth is forecast to be around 10.8% for the S&P 500, as of September 18th, based on data from Refinitiv. That's up a little bit from where we were in July when they stood at 9.5%. However, the current expectations are significantly lower than the historical average over the last 35 years, which has been around 12.25%.
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That leaves us with an S&P 500 that is trading around 20.5 times one-year forward earnings estimates. It means that when we adjust that PE ratio for the long-term earnings growth rate, we find that the S&P 500 is currently trading with a growth-adjusted PEG ratio of about 2. Historically speaking, the high end of the range has been 1.6, going back to 1985, with an average of 1.25. Typically whenever the S&P 500 gets to a long-term growth to PE ratio above 1.6, the market pulls back substantially. Supposing, we assume that the S&P 500 is to trade with a PE ratio of 1.6 times the expected growth rate. The S&P 500 would have a one-year forward PE ratio of about 16.76, making the S&P 500 worth about 2,650, a decline of about 18% from its current level on September 18th.
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Technicals Breaking
More concerning is what's taking place in the S&P 500 on the technical charts, with the index now falling out of what looks to have been a descending triangle around the 3,340 region and now falling below a critical level of technical support at 3,260. It could result in the next level of support not coming until 3,175. But the real threat that the S&P falls to somewhere around 2,860, a decline of about another 12% from where the S&P 500 is trading. A move to 2,860 would allow the index to fill a technical gap created in the middle of May. It would also let the S&P 500 retrace about 50% of the move off the March lows,
Additionally, the S&P 500 has an RSI that's currently around 35. Which is still not even oversold. We would need to see the RSI fall below 30 before we consider the S&P 500 to be oversold due.
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Should the current downdraft in the markets continue, it is likely to take either a major shift in sentiment to unwind the current downdraft. Or investors are going to start having to find pockets of the market that represent some form of value from a fundamental standpoint. In the absence of both, this sell-off may get worse before it is due to get better.
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