July 25th, 2023

Is Wall Street’s Optimism Justified?

I’m worried (for you) that the current rally is getting way ahead of itself so as I sit in for Jeff Wood this week, I want to share key metrics today which can help us prepare for a potential correction (not a resumption of the bear market).

Today, I want to begin by looking at the valuation of the S&P 500 as this is the first indication to me that a correction is likely.

Let’s take 2024 projected earnings for the full S&P 500, which are currently projected at $240, versus 2023’s earnings projection which is $225.

Wall Street is projecting 6.6% growth in earnings, year over year, from this year to next. This comes at a time when we have three possible economic scenarios:

Soft Landing: some deterioration in earnings performance related to higher unemployment and slower growth.

No Landing: Earnings and growth remain consistent, despite higher interest rates and continued higher inflation.

Hard Landing: The Fed screwed up and raised rates too high and killed growth, dead.

The only scenario among those which can support +6.6% growth in earnings is the “No Landing” scenario. A soft landing would lead to a decline in earnings, perhaps on the order of 5% (for the full S&P 500). A hard landing would lead to a significant decline, at least 15% and perhaps much, much higher.

So, keep hoping for Soft/No Landing, because that’s what Wall Street is doing right now.

Given that background, we can use that information to project the value of the S&P 500 into the future:

How to Read This Table:
I begin with EPS, or Earnings per Share, for the S&P 500 for 2024. Remember that market pricing is typically 6-12 months into the future, so we’re looking ahead to determine what the market is willing to pay for stocks at specific earnings levels.

Soft Landing: $228 EPS

This is a 5% reduction in full year earnings expectations for 2024, multiplied by 17, 18 and 19x multiples (what the market is willing to pay).

As you can see, we’re already well above these levels in the S&P 500, which means Wall Street is NOT pricing in a soft landing (and certainly isn’t pricing in a hard landing).

No Landing: $240 EPS

This is the current situation, and we see is that Wall Street is already pricing in 19x to 20x multiples for 2024; which means two things:

Wall Street does not anticipate a recessionary event
Every piece of economic data must be ‘perfect’ going forward, or that $240 EPS isn’t likely

The other issue here for traders and investors is that there isn’t much “upside” available. The growth rate from 19 to 20x is just 5% higher in the index.

Growth Surprise: $250 EPS

File this away in the ‘not likely’ category, but I include it because we must consider all possibilities. What this EPS / Multiple combination tells us is this:

The S&P 500 is already trading above an 18x multiple, and yet,
The S&P 500 would still have limited upside (11% from current level to 5000 on the S&P 500, which would be an all-time high once reached)

This is why I stress to you that the market is getting ahead of itself.

It’s also worth noting that historically, the S&P 500 has risen rapidly just prior to recessionary events.

Keep that in mind – even though I am NOT bearish. I do think we’re overdue for a small correction.

In fact, in tomorrow’s newsletter, I’ll show you how to use the table above to hedge your portfolio in the event a correction (or worse) occurs.

See you tomorrow morning…

John Hutchinson
Traders Reserve