The big difference between today and the 1980s: Valuations

The figure below shows two main graphs. The graph at the top shows the Fed funds rate from 1978 to 1987, approximately the period in which Paul Volcker served as Chair of the Federal Reserve. Rate hikes preceded the 1980 recession. Rates were raised again around 1981, then reduced, and then raised again; leading to the 1981-1982 recession.

The graph at the bottom shows the U.S. 10 Year Treasury yield, the CPI inflation rate (left scale), and the value of the S&P 500 index (right scale). Note that the U.S. 10 Year Treasury yield generally followed the Fed funds rate in the period, and that both were high while CPI inflation was still within approximately two-thirds of its previous peak. Interestingly, the S&P 500 was mostly flat during this period of major turmoil.

Could one conclude that the Fed’s current hiking cycle to combat inflation may have a similar outcome – i.e., a period where the S&P 500 is mostly range-bound? While it is possible that the answer to this question is “yes”, there is a big difference between today and the 1980s, namely valuations. The figures below show the valuations in the 1980s and now.

As you can see, valuations in the 1980s during the two recessions were largely below 10, whether we look at the S&P 500 PE ratio or the corresponding inflation-adjusted Shiller PE10 ratio. Today they are slightly above 20 (PE ratio) and 27 (PE10 ratio). The video linked below discusses these and related issues, as well as some recent developments.

A simulation-based valuation of the S&P 500: February 2023

The figure below shows two simulation-based valuations of the S&P 500. They assume a fair price-to-earnings (PE) ratio for the S&P 500 that is the inverse of half of the 10-year U.S. Treasury yield. The price (at the top) is the most recent top value of the S&P 500.

The numbers on the left consider a more benign scenario: S&P 500 earnings in 2023 are up by 4.70% from the previous year, and the 10-year U.S. Treasury yield is at 3.73%. The numbers on the right refer to a less positive scenario: S&P 500 earnings are up by 4.70%, and the 10-year U.S. Treasury yield is at 4.30%.

The second scenario takes us to a fair price for the S&P 500 of 2,537.50, which is 47.34% down from the most recent high. The video linked below discusses these simulations, some of the most recent values for the simulation inputs, and a few other things.

A simulation-based valuation of the S&P 500: January 2023

The figure below shows two simulation-based valuations of the S&P 500. They assume a fair price-to-earnings (PE) ratio for the S&P 500 that is the inverse of half of the 10-year U.S. Treasury yield. The price (at the top) is the most recent top value of the S&P 500.

The numbers on the left consider a rather benign scenario: S&P 500 earnings in 2023 are up by 4.70% from the previous year, and the 10-year U.S. Treasury yield is at 3.49%. The numbers on the right refer to a more likely scenario: S&P 500 earnings are up by 4.70%, and the 10-year U.S. Treasury yield is at 4.22%.

The second scenario takes us to a fair price for the S&P 500 of 2,667.12, which is 44.65% down from the most recent high. The video linked below discusses these simulations, some of the most recent values for the simulation inputs, and a few other options.

A simulation-based valuation of the S&P 500: December 2022

The figure below shows two simulation-based valuations of the S&P 500. They assume a fair price-to-earnings (PE) ratio for the S&P 500 that is the inverse of half of the 10-year U.S. Treasury yield. The price (at the top) is the most recent top value of the S&P 500.

The numbers on the left consider a rather benign scenario: S&P 500 earnings in 2022 are up by 5.60% from the previous year, and the 10-year U.S. Treasury yield is at 3.75%. The numbers on the right refer to a more likely scenario: S&P 500 earnings are up by 3.10%, and the 10-year U.S. Treasury yield is at 4.00%.

The second scenario takes us to a fair price for the S&P 500 of 2,644.39, which is 45.12% down from the most recent high. The video linked below discusses these simulations, some of the most recent values for the simulation inputs, and a few other options.

Do equity indices bottom before recessions?

An interesting debate taking place right now (November 2022) relates to whether the equities market has already priced in a recession, and is now moving up into what could be a new bull market. This could mean that the forward-looking equities market, represented by equity indices (e.g., Wilshire 5000, S&P 500), has bottomed before a recession.

I have conducted a rather extensive review of various equity indices to see if there is a historical precedent, prior to November 2022, for an index that has bottomed before a recession. I could not find any. The figure below (source: Federal Reserve Bank of St. Louis) shows the Wilshire 5000, which covers all American stocks.

The figure shows two areas where the index bottomed after a recession and during a recession. These are only illustrations of a broader pattern - I could find no instance in which a bottom occurred before a recession, in any index (including the S&P 500). So, do equity indices bottom before recessions? Apparently not. The video linked below discusses this and other cases in more detail.

A simulation-based valuation of the S&P 500: October 2022

The figure below shows two simulation-based valuations of the S&P 500. They assume a fair price-to-earnings (PE) ratio for the S&P 500 that is the inverse of half of the 10-year U.S. Treasury yield. The price (at the top) is the most recent top value of the S&P 500.

The numbers on the left consider a rather benign scenario: S&P 500 earnings in 2022 are up by 10% from the previous year, and the 10-year U.S. Treasury yield is at 3.00%. The numbers on the right refer to a more likely scenario: S&P 500 earnings are up by 5%, and the 10-year U.S. Treasury yield is at 4.00%.

The second scenario takes us to a fair price for the S&P 500 of 2,693.12, which is 44.11% down from the most recent high. The video linked below discusses these simulations, some of the most recent values for the simulation inputs, and a few other options.

A simulation-based valuation of the S&P 500: August 2022