The end of selling pressure in the SPX over the past few days has led some analysts to believe the market is attractive here. They point to reasonably prices valuations, oversold conditions, and widespread bearish sentiment. However, I continue to believe the risk-reward outlook is negative, from both a short and long-term perspective. Regarding the former, we are nowhere close to the levels of capitulation seen at past significant market bottoms. Regarding the latter, long-term return prospects remain far too low to justify the risk of capital losses.
Various sentiment surveys currently show extreme levels of pessimism among investors. Last week's investor intelligence Bull/Bear ratio is below 1 which has often been a sign that the market is about to bottom out. However, as we saw during the 2007-2009 bear market, sentiment can remain depressed for long periods as stocks continue to decline.
A more useful gauge of the potential for a strong rally over the coming months is the VIX volatility index. When demand for put options surges as traders look to hedge their equity positions and the supply of put option writers declines, implied volatility spikes and this is often a signal that stocks are poised to post a strong rally. The VIX is not currently at levels that imply capitulation.
It is often the case that a decline in the VIX slightly precedes short-term recoveries in the SPX, particularly if new lows in the SPX are not confirmed by now highs in the VIX, and this could certainly be the case this time around. However, as we saw in 2008, a retreat in the VIX led to only a minor rally in the SPX before selling pressure returned.
The SPX now trades at a forward PE ratio of 17.8x, having fallen from a peak of 27.2x in January 2021, and this is being used by some investors to argue that stocks are cheap. The problem here is that this forward PE ratio implies profit margins of over 13%, which is more than double the long-term average. I have written numerous articles about the likelihood of downside profit margin mean reversion and its likely impact on equity returns (see 'SPX: Expect A Bear Market In Profit Margins'). I fully expect to see profit margins fall back to their long-term average which is why I prefer valuations measures that strip out their effect. Such metrics, such as the price-to-sales ratio and market cap/GDP have been much more closely correlated actual subsequent SPX returns in the past, and they remain at levels that strongly imply negative total returns for many years to come. Even since 1990 where profit margins have been above average and rising, the correlation between the price-to-sales ratio and 10-year returns has been extremely strong. Currently, with the ratio still above 2.5x, the correlation implies negative total returns of 5% per year for the next decade.
Another way to estimate long-term returns is to take the current dividend yield, add to it the rate at which dividends are expected to growth, and try to gauge where the dividend yield will move to in the future. With a dividend yield of 1.6% currently, if they grow at the same rate of trend nominal GDP of 4% over the next 10 years, this would result in 5.6% annual returns assuming no change in the dividend yield. While this may seem reasonable, long-term annual returns have been closer to 10%. Even if return expectations were to rise just 1 percentage point to 6.6%, the decline valuations required for this to happen would be enough to fully offset dividend income over the next decade.
One of the main justifications of high stock prices over the past two years has been easy monetary policy, and specifically the widespread belief that the Fed would prevent any meaningful decline in stocks. With inflation now a major political issue, it should be clear that any efforts by the Fed to ease policy in favor of supporting stocks will be very difficult to get off the ground.
Note that I do not believe that rising yields are a major cause of the recent weakness and therefore do not believe that a reversal in monetary policy would provide much help to the SPX. The bear markets of 2000-2002 and 2007-2009 are all the evidence you need to know that once investors put return of capital above return on capital, even significant easing does not prevent major market declines.
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Disclosure: I/we have a beneficial short position in the shares of SPX either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.