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Moderate equity valuations reduce downside risk

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The S&P 500 has gained 27% in 2021, yet most US stocks are cheaper today than they were a year ago.

Of course, prices are on the rise, as anyone who has looked at their year-end 401(k) statement knows. Valuations, however, are down considerably. The S&P 500 started 2021 with a price-earnings ratio of 30.7, based on reported earnings over the previous 12 months. He ended the year with a PER of 23.6.

By this measure, stocks started this year 23% cheaper even after the outstanding 12-month performance.

If this sounds contradictory, allow us to simplify: the “e” of the stock market P/E ratio has risen faster than the “p”. Collectively, earnings for S&P 500 companies rose 65% in 2021, well above the index’s 27% gain.

The numbers, of course, need to be seen in context. Since 1989, the average year-end P/E ratio for the S&P 500 has been 19.6, according to data compiled by Charlie Bilello at Compound Capital Advisors. In other words, current valuations represent a 20% premium to the 33-year average while still looking like a bargain compared to January 2021.

Perhaps then the real question is this: which number is more relevant?

Some argue that the longer-term average encompasses a wider variety of economic conditions. Others suggest that the value of an ocean of central bank liquidity has rendered much of this story obsolete, or at least different enough to disqualify it as a suitable point of reference.

It’s certainly true that the Federal Reserve’s historically loose monetary policy has skewed what most investors consider a “fair valuation.” It seems logical, at least in hindsight, that a historically high dose of Fed-induced stimulus would lead to historically high stock market valuations, which is exactly what happened. The 30.7 P/E from a year ago was the highest of this 33-year-old sample.

Here’s what we know: Inflationary pressures have become strong enough to force the Fed to act. Jerome Powell has already started cutting Fed stimulus and interest rate hikes are coming, probably in March or April.

We have written countless times that Fed policy is the single most important driver (in modern times) of short-term market movements. It must therefore be recognized that the recent shift towards a less accommodating Fed policy will have a negative effect on asset prices.

How much anyone can guess, but the already significant drop in P/E ratios can be attributed to two things: weaker earnings growth and a less friendly Fed. The market is already pricing at least some of the upcoming “Fedwinds”.

As to whether current stock market valuations should be considered attractive, consider this: the average year-end federal funds rate since 1989 was 2.7%. Today it is close to zero.

Even if Powell & Co. are brave enough to raise rates by 200 basis points (think: eight separate hikes of 0.25% each), the rate will still be well below the 33-year average. It is appropriate to expect P/E ratios to remain above their historical averages under such conditions.

That doesn’t mean stock prices can’t go down. The S&P 500 and the Dow Jones Industrial Average remain within a few percentage points of their all-time highs. A steeper decline at some point is inevitable.

Momentum and sentiment also matter, and both have weakened since last fall. Nonetheless, the fact that valuations have come down significantly from a year ago reduces the decline in equities and should soften the blow in the next correction.

Ben Marks is chief investment officer at Marks Group Wealth Management in Minnetonka. He can be contacted at [email protected] Brett Angel is a senior wealth advisor at the firm.

Sources

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2/ https://www.startribune.com/moderate-stock-valuations-reduce-downside-risk/600136166/

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