S&P 500 could drop more than 10% as stock valuations crumble

The S&P 500 fell by 1.3% yesterday as the 10-year Treasury yield hit 3%.  Fearful investors are now starting to question whether lofty stock valuations are still justifiable.

Indeed, one of the abiding beliefs in this bull market has been that exorbinant stock valuations were justified because of low interest rates.  The price-to-earnings ratio of the S&P 500 is 53% above its historical mean (more on that later).

The assumption was that if the 10-year risk free rate is this low, then the present value of a company’s discounted future cash flows justify a high valuation.  That assumption has now broken down.  Interest rates climbed to past 3% yesterday and will likely head even higher in the coming months.

A number of technical analysts have predicted that 10-year Treasury yields could rise to 3.4% rapidly once it breached 3%.  The stock market will test this thesis in the coming weeks.

This is why investors have started to stampede out of the stock market.  And there is likely more trouble ahead as …

Stock valuations to crumble as they revert to the mean

The historical average for the S&P 500 price-to-earning (P-E) ratio is 15.7-times.  The S&P 500 current price-to-earnings ratio is a lofty 24-times.  That means S&P 500 is overvalued by a whopping 53% relative to its historical average.
Price-to-earnings ratio shows that stock valuations are very high.
Stock valuations were already very high but have run up even higher over the last couple of years.

And that’s not the only measure that well above the historical average.  The S&P 500’s price-to-sales ratio is 2.14 — that’s just a smidge below the all time high set in December.  Moreover, that’s about 44% above its historical average.

Investors recognize that this time is not different.  Accordingly, investors will start to march out of overvalued equities ad lofty stock valuations will crumble.  A reversion to the mean could easily knock 10% to 20% off the stock market’s value.

This is less than the overvaluation indicated by the historical data due to two factors.  First, President Trump’s corporate tax cuts are kicking in and that will boost earnings for the rest of this year.

Effectively, the denominator in the P-E ratio will rise and bring the ratio down somewhat on its own.  That leaves less room for the reversion of the mean effect to pull down valuations.

Second, the US and global economy continues to grow, albeit more slowly.  Well-run companies will be able to squeeze out more organic earnings growth from the economy.

See more of our analysis here.

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Al Basoglu

I am a financial services professional with over a decade of experience in various roles. I've lived and worked abroad in 5 different countries while pursuing personal and professional challenges. My interests include markets, history and different cultures. I tend to weave all of my interest into my analysis and articles.