This is an excerpt from our May 11, 2022 Morning Briefing.
Strategy I: 1987-Style Bear Market? I've recently been asked when was the last time we had a P/E-led bear market while earnings continued to increase. The obvious answer is 1987. Our monthly Blue Angels framework, which starts in late 1978, shows that the S&P 500 dropped 33.5% from August 25, 1987 through December 4, 1987 (Fig. 1). From August through December, the forward P/E fell from 14.8 to 10.5. Over that same period, forward earnings rose 6.3%. The bear market lasted just 101 calendar days.
Of course, during the latest bull market, there have been 72 panic attacks, by our count, from 2009 through 2021 that included six corrections of 10%-20%. But none of them turned into bear markets because the swoons in the P/Es were quickly reversed once investors got over their fears of an imminent recession, as confirmed by the ongoing uptrend in forward earnings (Fig. 2 and Fig. 3). Arguably, the 33.9% drop in the S&P 500 in early 2020 was a bear market, but it lasted only 32 calendar days. So we included it in our list of panic attacks.
The jury is out on the latest correction. The S&P 500 fell 16.8% from January 3 through May 9. If it falls another 3.9%, the jury would have to come back with the obvious verdict: The correction has turned into a bear market. The selloff so far was triggered by two much more persistent panic attacks than the previous 72. On January 5, the Fed released the minutes of the December 14-15, 2021 FOMC meeting revealing that the committee's members were turning much more hawkish and were discussing quantitative tightening. The consequences of both developments are still ongoing and not in a good way for stocks and bonds.
Nevertheless, even if the current selloff turns into a bear market, it could be short-lived, much as was the 1987 episode. As we've been monitoring every week since the start of the correction, the forward revenues and forward earnings (both on a per-share basis) and the forward profit margins of the S&P 500/400/600 have remained on solid upward trends rising in record high-territory (Fig. 4, Fig. 5, and Fig. 6).
Of course, the big difference between now and 1987 is that inflation is a much more serious problem currently. In response to the 1987 stock crash, then-Fed Chair Alan Greenspan first introduced the Fed Put. This is the first year since then that the markets have been forced to discount that the Fed can't provide the put because it must fight inflation. Hence, market participants have concluded that it's never a good idea to fight the Fed, especially when the Fed is fighting inflation.
While the bulls (including yours truly) have been getting clawed by the bear, we are hoping that there will be less inflation for the Fed to fight in coming months. On Monday, Debbie and I observed that the 3-month inflation rates at annual rates have fallen below their 12-month rates for several key measures of consumer prices and wages.
On Tuesday, the survey of consumers' expectations conducted monthly by the Federal Reserve Bank of New York found a slight downtick in the one-year series of consumers' expected inflation rate from 6.6% in March to 6.4% in April (Fig. 7 and Fig. 8). That's not much, but at least it wasn't an uptick. Not surprisingly, this series closely tracks the actual headline PCED inflation rate.
Strategy II: Real Earnings Yield. With the benefit of hindsight, one of the valuation measures that signaled imminent trouble for stocks was the real earnings yield (Fig. 9 and Fig. 10). It tends to signal an impending recession when it turns negative, i.e., when the spread between the nominal earnings yield of the S&P 500 and the y/y CPI inflation turns negative. It hasn't called every bear market, but it has called many of them. This time, it first turned slightly negative (-0.2%) during Q2-2021 and significantly negative during Q1-2022 (-3.9%).
Interestingly, the real earnings yield works relatively well as a business-cycle indicator. It tends to turn negative before recessions. Indeed, it is highly correlated with both the Index of Leading Economic Indicators (LEI) on a y/y basis and the spread between the 10-year Treasury yield and the federal funds rate, which is one of the 10 components of the LEI (Fig. 12).
The good news is that neither the LEI nor the yield-curve spread is currently signaling a recession, which reduces the credibility of the signal sent by the negative real earnings yield. This is another reason why the current selloff in the stock market might be more like 1987 than like deeper and longer-lasting bear markets. There was no recession in 1987.
Strategy III: Stock Prices During Great Inflations. What does the S&P 500 do during inflationary periods? Since the early 1920s, the CPI inflation rate, on a y/y basis, has had a tendency to spike up before recessions and to spike down during and after recessions (Fig. 13). So, not surprisingly, the inflation rate has a similar relationship with bear markets in the S&P 500 (Fig. 14).
The Great Inflation of the 1970s, which actually started in 1965, weighed greatly on the S&P 500 (Fig. 15). In nominal terms, the index increased just 27.4% over the entire period. Adjusted for inflation using the CPI, it fell 48.2% over this entire period.
We continue to expect the current decade will turn out to be more like the Roaring 2020s than the Great Inflation of the 2020s. If so, then the long-term outlook remains bright for the S&P 500.
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