The valuation of the U.S. stock market has fallen faster than in the aftermath of the dot-com crash, recording the biggest six, 12 and 18-month drops since data on price-to-forward-earnings ratios began in 1985. That should be only a slight consolation to investors.

Start with the good news, such as it is: Cheaper stocks are a good thing for those investing now, and they’ve become a lot cheaper in a very short time. The S&P 500’s valuation hasn’t fallen quite so fast as the overall market, but on a longer-term measure—Yale professor Robert Shiller’s cyclically-adjusted price to earnings—the drop from November’s peak was bigger over such a period only twice since 1881, after the 1929 and dot-com crashes.

Unfortunately valuations were able to fall so fast because they were so high to start with. Unlike in 1999-2000, the only previous time they were higher on either the IBES forward PE or the Shiller PE measures, valuations were elevated primarily because bond yields were so low. Low bond yields made future profits much more attractive, pushing up the value of every dollar of those expected earnings. With bond yields soaring this year, it should be no surprise that valuations plunged.

Here we come to the bad news. Wall Street has only just begun to worry that earnings might fall too. Even as valuations were dropping, analysts continued to upgrade their forecasts for profits for most of the year—until a few weeks ago. Now forecasts are being slashed, and investors are increasingly convinced that a recession is on the way, which would crush earnings. Analysts shifted rapidly: In late May upgrades still outnumbered downgrades, but so far this month downgrades outnumber upgrades by two to one.

Bring this back to valuations, and it looks dire. If forecast earnings fall, the valuation—price divided by predicted earnings—rises. That would be fine if shareholders had dumped stock in anticipation of the lower earnings that Wall Street analysts are only now catching on to. But they didn’t. Almost all the fall in stocks up to early June was due to the effect of rising rates on valuations of those expected earnings, not the effect of tighter monetary policy on the economy reducing the earnings.

The chink of light is that after such a big fall, and with investors deeply gloomy, any good news could lead to a big jump in prices. One example: What Netflix Chairman and Co-Chief Executive Reed Hastings called “less-bad results” on Tuesday led the shares to jump 7% in after-hours trading, as the company lost only 1 million subscribers, half as many as expected.

The trouble is that good news on economic growth merely pushes the Federal Reserve to redouble its efforts to slow things down, which would add yet more pressure on earnings. What’s needed for more than a temporary bear-market rally is good news on inflation, which has been sadly lacking, or signs from the Fed that it might not be as hawkish as investors fear.

In the absence of such support, valuations are really only helpful if they suggest stocks are so cheap that bad news is all priced in. Needless to say, that is not the case.

True, the S&P at 16 times forward earnings is only a little more expensive than the average of 15.5 times since 1985. But remember that those expected earnings are very elevated, at 34% above the all-time high reached just before the pandemic. Put it this way: Even if earnings fell as much as they did in the aftermath of the dot-com bust, they still wouldn’t get back to where they were before the pandemic.

To think stocks are cheap requires us to believe that the pandemic benefits for companies—consumers flush with stimulus leading to high margins and high revenue growth together—will continue, or that there will be a further transfer from households to support profits. The first is the target of the Fed, and the second goes against the prevailing mood of politics. Much more likely is that earnings estimates come down, and that would make stocks look more expensive again, hardly helpful for prices.

This shows up in the still-high Shiller CAPE, which looks at 10 years of trailing earnings, adjusted for inflation. It isn’t affected by the optimistic Wall Street predictions, so remains among the most expensive it has been outside the bubbles of 1929 and 1999-2000.

One huge caveat is needed: Valuations offer no guide to short-term market moves, where sentiment and daily news dominates. This is all about when U.S. stocks are a good entry point for the long-term investor. At the moment, they look a lot cheaper than a few months ago, but still not cheap.

SOURCE :- WSJ