Last month, I was bearish on the S&P 500. After revieiwng the S&P 500’s valuation metrics again as of the beginning of the month of July, there’s still no indication that the index has reached a bottom. Many investors are seemingly interested in investing in the S&P 500’s bear market dip at the moment. However, the risk-return profile of the index remains poor by my estimates.
Statistical metrics
The S&P 500 has dipped below its GF Value, which implies optimism. The “buy low, sell high” saying should never be forgotten as bear market drawdowns often provide lucrative entry points. Even if you can buy near the bottom rather than at the very lowest, it’s still better than buying high.
However, on the flipside is the Federal Reserve model, which suggests that a convergence between earnings yield and the 10-year bond yield is en route. By this measure, the S&P 500 would be overvalued statistically.
Source: Yardeni Research
Furthermore, the ratio of total market capitalization to GDP chart reveals that the U.S. market still trades at a significant premium to the nation’s economic growth. If we observe the bull market between 2010 and 2021, it’s clear that much of the U.S. stock growth was realized when the total market capitalization was at a discount to U.S. GDP.
Macroeconomic outlook
To contextualize the statistical argument, we need to comprehend the global economic outlook. According to JPMorgan (JPM, Financial), China’s PMI receded in June despite re-openings of the economy. As such, there’s much concern that the global supply-chain issues could persist for the time being. Moreover, new orders have traded downward for an extended period of time, implying that the demand side of the economy is retracing.
Source: Markit; JPMorgan; S&P Global (SPGI, Financial)
U.S. inflation remains resilient, which has caused the yield curve to skyrocket. Even if the Federal Reserve utilizes contractionary monetary policies to stabilize price levels of goods, we’re likely to see a further erosion of spending power, which could affect even the large companies listed on the S&P 500.
Source: U.S. Inflation Calculator
Lastly, let’s look at the yield curve in more detail, which adds substance to the rest of the economic argument. The yield curve implies interest rates of more than 3% in the long-term and is heading for inversion, which is a vital indicator of a recession.
If a recession does surface, it’s unlikely that the S&P 500’s earnings yield will resume its ex-post linear growth rate.
Concluding thoughts
Based on statistical evidence and economic indicators, the S&P 500 remains overvalued. Many temporary surges might occur in the next few months. However, they’re likely to be short-lived as the composite reverts to its future fair value.
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