The Bernanke-inspired sell-off the past two days actually comes as welcome news - and not because I am short the market. Maybe I just don't drink the same Kool-Aid that everyone else does, but I get concerned when the trend gets too far out of control and it has been out of control for much of this year.
I recently wrote an article about why it was time to get into the VXX - iPath S&P 500 VIX Short Term Futures ETN - for a short term portfolio hedge ("Time to Add Some Volatility to Your Portfolio"). The premise of that article was the VXX had a long-term negative 1:1 correlation with the S&P 500 (SPY), but that correlation had, just this quarter, broken down. At the time, both the VXX and the SPY had moved higher by 4.2 percent and 3.9 percent this quarter, respectively.
In that article, I also made note of the following chart, which shows there is a 0.87 correlation between the Federal Reserve's balance sheet and the S&P 500. Given that correlation over the past five years, it is only logical that Bernanke's announcement that he will begin to taper would send stocks headed lower.
But, ultimately, I believe this sell-off is a good thing for the market - as the outcome will show us where fair value might be. I believe that we will see the market return to a more reasonable forward P/E of 13, sending SPY to $150.00 - or another 5 percent decline. This, not coincidentally, also corresponds to February's low of SPY $149, and would represent roughly an 11 percent decline from the all-time high.
Earnings Growth Spurred by Cost Cutting
While Q1 saw record profits, the basis of corporate earnings was cost cutting, sending up a caution flag for future margin growth. Revenue growth has lagged growth on the bottom line. First quarter revenue growth was expected to come in at 1 percent - compared to profit growth of 5 percent. In addition, less than half - 200 - of the S&P 500 were expected to report revenue growth of 5 percent or more.
Without revenue growth driving profits higher, companies will have to continue to look to increase margins - something that naturally becomes increasingly challenging. As the below chart demonstrates, profit margin is near 2007 highs.
The S&P's trailing P/E ratio rose to a multiple of 18.3 times as of last Friday, while the forward P/E gained to 14.9. Historically, this is not particularly high; the S&P 500 traded around 16 times forward earnings in 2007 and a staggering 28 times forward earnings in 2000.
However, in an economic climate where real GDP growth is anemic and real disposable personal income shrunk in Q1 at the fastest rate since 2009, I believe that this forward valuation is rich.
As the chart above shows, the S&P 500 traded at a forward valuation capped at 13 times earnings for much of 2010 through early 2013, when economic growth was higher. In recent history, only during the boom of 2006-2007 was the valuation richer. Expecting that the S&P 500 returns to the 2010-2012 valuation, I predict that SPY falls to $150.
Earnings Season Paramount
Fundamentally, the S&P 500 rallied through Q1 earnings season, though at this time, the market was still on a QE3 high. As noted above, earnings last quarter were not particularly strong, with weak revenue growth despite record profits.
This earnings season, I will be watching to see if companies start to report more top-line growth that trickles down to the bottom line. If we see a trend, it would not be surprising to see the SPY shake off these recent losses and move back towards recent highs. But, I believe that is a big mountain to climb.
Given that the bottom-line corporate growth has been driven more by cost cutting than economic expansion, and the impending Fed tapering shrinking the Fed's balance sheet, returning to a recent, more conservative valuation of 13 times forward earnings seems in the cards - putting the S&P 500 index at 1,500 given current expectations.