This week we thought we’d better discuss the stock market and our latest thinking. In the past two weeks, the S&P 500 has declined by nearly 10% (as of this writing) and is back down to the lows for the year last reached in mid-June. Year-to-date (ytd), the S&P 500 has declined by almost 22%. Our stock benchmark the MSCI World Index is also at new lows for the year having fallen nearly 23% ytd. Fortunately, our positioning has performed much better than these broad market indices this year.
With the S&P now trading at 3,670, we thought it would be helpful to remind you of our previous estimates of fair value and update you on our current thinking.
On May 13th , 2022, we sent out a note with details behind our fair value range of 3,400-3,900 on the S&P 500. This range was based on our estimates for earnings for that index of between 200-230 for 2022. The 200 eps was our recession scenario with the 230 eps our bull case steady growth scenario. At that time, our portfolios were at 68% of benchmark equity—meaning we were significantly underweight stocks relative to benchmarks. For example, balanced accounts with a benchmark allocation of 60% to stocks would have only held 41% of the portfolio in stocks at that time.
On June 10th and July 7th, the weekly thoughts notes added more detail to our view on stocks and reaffirmed our fair value range of 3,400-3,900 on S&P 500. You’ll remember that when the market fell to the lows for the year in mid-June, we began adding incrementally to our equity positions. We paused equity purchases when the market shot up past our fair value range in July. As of yesterday, our portfolios were at 75% of benchmark equity—still very underweight stocks relative to benchmarks.
Now that stocks have returned to our fair value range, it is time to give you an update on our latest thinking.
As of this week, Wall Street consensus earnings for the S&P 500 is 225.3 for 2022 and 243.5 for 2023. These have been reduced slightly over the last few months as analysts increase their probabilities for a recession. We think that the likelihood of a recession in 2023 has increased a lot in the last two months due to the actions of Federal Reserve. The central bank has increased interest rates five times in the last six months. The fed funds rate has increased by 3 percentage points over that period—the largest six month increase since 1981. Based on this we’ve updated our eps estimates for 2022 to a range of 215-220 and for 2023 to a range of 200-230. In the July 7th note, we included a chart showing the S&P 500 eps declines for the last 10 recessions. On average earnings declined by 13% in those events, so our 200 eps recession estimate for 2023 isn’t that draconian.
If analyst are correct about 2023 eps of 243.5, then the US Large Cap stocks look pretty cheap trading at 15x 2023 eps. Remember, the long-term forward price-to-earnings ratio for the S&P 500 is 16.7x. Applying this long-term Fwd P/E ratio to our estimates gives us a range of 3,340-3,841. This range of fair value does not include the possibility of a banking crisis or global macro event like 9/11 or similar. When those types of events occur, stocks react violently as we saw in 2001 and 2008.
So, with stocks trading in the middle of our fair value range, we are inclined to add equity exposure to portfolios. Like we said in the May 13th note, we might be early but we aren’t trying to time the market short-term. We are looking to invest where there is good long-term risk/reward.
At current prices, US Large Cap Stocks have a 10-year expected return of around 7% and our benchmark index (MSCI World) has an expected 10-year return of close to 7.8%. Compare those expected returns to our estimate of 10-year expected returns for our fixed income benchmark (US Aggregate Bond Index) of 4%. While being overweight fixed income relative to stocks has been good for our clients this year, we don’t think it will be the right positioning over the long run.
