The market fell 9% this week. The worst weekly drop since the depths of COVID. The trade “solution” was a disaster. If left unchecked, this has the potential to do some real damage.
But valuations are now getting closer to their long-term averages. Dividend yields are at a 12-month high. And the equity risk premium is at a 2-year high.
I wrote last month that as it became evident to me that trade policy no longer appears to be “negotiating tactics”, the probability of a valuation reset was rising. That meant a drop to the 4600 level in the S&P 500.
As we rolled over to a new quarter, forward EPS estimates rose to $278.96 on Friday. The long term average forward PE is 17x (red line on the above chart) according to my calculations. So 17x current EPS estimates gives us a “valuation reset” of 4750 on the S&P 500. Which is still another 6% lower.
Trailing EPS or earnings that have already been reported over the last 12 months, is $248.66 as of Friday. And the historical average trailing PE is 18.6x. So 18.6x current reported EPS of $248.66 gives us a “valuation reset” target of 4632. Which is about 8.7% lower.
Interest rates have fallen from as high as 4.8% this year, to 3.99% on Friday’s close. As a result, the equity risk premium (or S&P 500 earnings yield minus treasury rates) is back in positive territory and at a 2-year high.
The dividend yield rose to 1.47%, which still isn’t great, but it’s a 12-month high.
Along with the valuation reset targets I mentioned (between 4632 and 4750), I’ll be watching for a spike in the VIX that takes out last July’s high of 65, possibly signaling a capitulation.
The problem with this analysis is that it doesn’t take into account the probabilities of a more than mild recession that may result if these trade policies do not get redacted. Valuations may reset back to average, but if earnings drop 10%+ on top of that, well lets hope we don’t have to find out.