As we move deeper into this bear market, it is useful to think about how deep the sell-off may go.  As usual, everything depends on how committed the Fed is to fighting inflation and how quickly inflation comes down.  My best estimate is that we are looking at a best case of a 3400 bottom on the S&P 500 if the Fed only has to tighten moderately to lower inflation to 2% and a worst case of a 3000 or lower bottom if the Fed has to tighten more aggressively to hit its 2% target. I say that believing that 2% will not represent an accurate measure of real world inflation (which is much higher), but that is the marker the Fed will use.  I also doubt that official inflation will drop to 2% but will more likely remain closer to 4-5% at year end, leaving the Fed with the tough choice between fighting inflation and propping up a struggling stock market and slowing economy (though one not technically in recession – two consecutive quarters of negative growth - by 4Q22). 

Forward four quarter S&P 500 earnings estimates are currently $235.25 according to Refinitiv, leaving the index trading at a 16.5x multiple at the close of trading on Friday, May 20th.  Assuming for the purposes of this discussion that this earnings estimate remains unchanged (it will probably be lowered), 3400 would take the multiple down to 14.25x.  At 3000, the multiple would drop to 12.75x and at 2800 it would fall to 11.9x.  These multiples would be pretty low but well above the 8-9x multiple seen during the Great Financial Crisis of 2008.  To see a single digit multiple, we would most likely require a deep recession rather than a mild or brief one (and right now few are calling for a deep recession because they expect the Fed to pull back before that happens). A moderate recession is very much in the cards in order for the Fed to squash inflation but for now that is unlikely until 2023 (2Q22 GDP is likely to be positive). 

For now, we can expect the Fed to raise rates another 100 basis points by July 4th and most likely another 50 basis points by Labor Day before considering a pause absent a serious market accident. It will also start slowly shrinking its bloated balance sheet shortly.  None of these actions will be market friendly and should place additional downward pressure on stock prices beyond those already experienced.

Those arguing that the bottom has been reached need to come up with better arguments that the ones they’ve put forth so far.  Stocks are not remotely cheap.  While the traditional S&P 500 P/E ratio is 16.5x, it is inflated by the fact that earnings are inflated by non-GAAP earnings adjustments; if earnings were calculated according to GAAP, the P/E ratio would still be well above 20x.  The Shiller Cyclically Adjusted PE Ratio shown above (which measures average inflation-adjusted earnings from the previous ten years) is still extremely elevated at 30.71x versus a mean of 16.94x.  Bear markets tend to overshoot on the downside especially when the Fed is no longer supporting them and the chart shows that the market has normally traded at lower valuations than today’s. 

The Nasdaq is still populated by many infinite duration stocks trading at high multiples of non-existent or microscopic earnings; these stocks will drop further in this kind of market because the air that supported them is being sucked out of the room.  (As an aside, I’ve seen tweets from prominent TSLA bulls arguing that TSLA is now cheap at $663/share. All I can say to that is that I’m happy these people haven’t lost their senses of humor; they are going to need them.)  Credit markets are also weakening significantly  HYG and JNK, the two largest high yield bond ETFs, are falling like stones as bond prices fall and bond yields rise and spreads widen.  Triple-C rated bonds now yield about 12%, up from an absurdly low 7% last year, but yields will go higher along with rates and defaults.  Risk assets falling simultaneously tells you all you need to know about the regime change occurring in financial markets.  Thinking this process is going to reverse anytime soon is wishful thinking.  Unlike any other time since the Great Financial Crisis, policymakers are hemmed in by record high inflation rates that limit their ability to prop up inflated asset prices.  This time markets are on their own.

For now, the best thing investors can do is stop thinking they must be invested in this market.  Investors should sharply cut their exposure to risk assets and not be lured back in by bear market rallies. Friday afternoon’s rally was almost certainly caused by position squaring due to triple witching options expiration, not anything fundamental.  Not only will sitting out the market for a bit relieve you of unnecessary anxiety but it will save you money and give you an opportunity to reenter positions at more attractive levels later.

The Fed has barely started tightening and unless it wants to cement its reputation as the most feckless group of central bankers in history, it has a lot of work to do to slay the inflation beast it unleashed and restore monetary stability to an extremely fragile system.