Where's the Market Bottom?

In late August, I told members of my TAZR Trader service we were selling enough stocks to take the portfolio to 60% cash. Here’s what I wrote...

While I think the market is over-reacting to Fed Chief Jerome Powell's Jackson Hole love note on Friday, we have no positive catalysts until earnings in October.

And that means that stocks can get beat up pretty bad in September, traditionally a weak month that looks like it's about to fulfill its destiny.

SPX 4,000 is not a significant support level and after the damage done to the new uptrend, it could easily fall and accelerate the selling.

Let's tighten the risk reins and look for better spots to ramp long.

The Math of the September Swoon 

I also explained why this particular September had its own unique drivers and mathematical dynamics; namely, an evaporation of the Equity Risk Premium.

On September 19, we even grabbed a leveraged short position in the S&P 500 with the index breaking back down below a key technical pivot at 3900.

The Equity Risk Premium is the metric that institutional investors use to put a handy valuation on the broad market vs. investments with little risk, like US Treasuries.

Because even though we can put a Price/Earnings ratio on the S&P 500, it still doesn’t give us enough information without also calculating the direction and speed of interest rates.

Here I will walk you through this simple math so we can figure out where -- and when -- the market will be more of a bargain than it is right now.

We start with the P/E for the market. Using projected 12-month forward earnings of about $230 against an S&P 500 index level of 3700, we get a P/E ratio of 16X (3700 / 230 = 16). 

But where did that $230 EPS number come from?

Two things to note about that S&P EPS number of $230:

1) It comes from analyst “bottom-up” estimates that are aggregated. Our Director of Research Sheraz Mian calculates this every quarter based on analyst earnings estimate revisions (our bread & butter at Zacks).

2) That number used to be closer to $245 only a couple of months ago. But July and August saw a big wipeout of profit forecasts that took down Q3 estimates by over 5%. That’s fast EPS deceleration!

Okay, so we’ve got our P/E. Now how do we compare this to the “risk-free” rate, aka US Treasury securities?

First, we have to “flip” that P/E into a number we can compare to the 10-year yield. So we just take the inverse, via 230 / 3700, and get 6.2%. Now we have what’s called the “earnings yield” of the market.

That’s something that gives us an “apples to apples” comparison to the 10-year Treasury note, which is currently near 3.8%.

The Big Idea Behind the Equity Risk Premium

The idea behind the Equity Risk Premium (ERP) is that we want to know how much more return stocks are offering over the risk-free rate. To find that, we simply take the difference: 6.2% - 3.8% = 2.4%.

And that’s your ERP. The stock market is currently priced, based on projected earnings and its price level, offering a 2.4% higher yield than the risk-free rate.

This “premium” to government securities is telling you this: how much stock investors want (or need) to be compensated for taking on the extra risk of owning equities. Thus the reason it’s called the Equity Risk Premium.

Continued . . .

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Now the Bad News

Is that 2.4% good? It seems okay. But remember just how volatile stocks can be. The S&P is down roughly 25% from its highs. That’s a lot more risk than you’re getting compensated for, right?

And yet, one could argue “Well stocks are on sale now, so shouldn’t we buy anyway?” But that doesn’t answer the question of whether stocks are “cheap” or “expensive.” Just because they’ve fallen a bunch, doesn’t equate to a bargain if something else is going on.

That “something else” is the direction and speed of the two primary inputs of the ERP: interest rates and earnings.

And if interest rates are still rising, and earnings are still falling, then that ERP is going to get smaller as stocks can barely compete with the risk-free rate.

BlackRock Says “Boo!”

Just last week, the economics team at BlackRock, the world’s largest asset manager with $10 trillion under watch, said that central banks are underestimating how much they will have to hike interest rates to kill inflation -- and potentially cause a recession. For this reason, “they shun most stocks” as the growth environment becomes so cloudy.

Remember, in the simplest terms, the US 10-year Treasury yield (i.e., the risk-free rate) is a cost of capital component, while the Equity Risk Premium is primarily a function of growth expectations.

We know the status of the first input. Interest rates are definitely on an aggressive upward path as the Fed is committed to taming inflation. Rates on the short end will go above 4% very soon. And that means the 10-year probably will too.

Unless the curve just goes inverted Mav, which it easily could if inflation expectations -- and actual CPI data -- cool off. This is because the 10-year will be a more accurate market gauge of the future, while the Fed is driven by politics and emotions since they lost the war on inflation over a year ago.

“Behind the curve” doesn’t begin to describe their predicament that might have them scramble too many fighters and knock the economy into recession.

This Puzzle Has a Solution 

Where does that leave us with stocks? When, and where, will the bottom show itself?

The market will bottom when institutional investors calculate that the risk/reward for stocks is much better than it is now. And institutional investors will see the market as very attractive again only when the ERP goes back above 3%.

It will take at least one of three things to make that happen:

1) Earnings stop going down. We won’t know that until this earnings season gets going and we see actual corporate report cards and hear the outlooks, concerns, worries, excuses, etc.

Then analysts will either rejoice that things aren’t so bad after all and a turn in the earnings cycle is at hand. Or they will cringe and clobber their models with more downward EPS revisions and price target evisceration.

2) Inflation and Interest rates stop going up (and preferably fall). Equally hard to gauge right now.

3) The price of stocks keeps going down. This will push up the ERP as the P/E drops.

My “When and Where” Forecasts for the Bottom

I have two basic scenarios in mind, both assuming that inflation subsides and the 10-year yield stays near 4% - even if it temporarily spikes to 4.5% in the next few months. This is a big prayer, I know. But let’s do the math anyway using it as a baseline for stocks getting cheaper by going down.

And remember this: even if the economy and stocks -- both sirens of growth expectations -- can survive with short and long-term interest rates above 4%, right now it’s all about the fear that they cannot. That’s why stocks continue to race to discount the probable recession, from the Fed firefight to tame the inflation blaze.

Scenario #1: Assume that earnings season is “not terrible” and estimates just go down a little bit to EPS of $225 for the S&P.

I project the market will bottom at S&P 3200 as the Equity Risk Premium claws its way back to 3% with this math: 225 / 3200 = 7% earnings yield.

7% - 4% = 3% ERP. That’s a P/E of 14.2X. And 11% lower from 3600.

Scenario #2: Assume earnings season is “terrible” on all kinds of worries (including the war in Europe) and EPS drops to $220.

I project the market will bottom at S&P 3000 as the ERP gets above 3% on this math: 220 / 3000 = 7.3%.

7.3% - 4% = 3.3% ERP. That’s a P/E of 13.6X. And 17% lower from 3600.

There, that wasn’t so bad, was it? By the way, these two scenarios form my “base case” with about 2 in 3 odds. The third scenario, with only a 33% probability, would be a big drop in rates + a reversal higher in earnings. That outcome would be fantastic -- S&P 4500 anyone? -- but not quite as likely as the base case of going down below S&P 3400.

The zone of S&P 3300 to 3400 also has some interesting technical implications as it forms the heart of the big market consolidation in Sep-Oct of 2020 as we recovered from the Corona Crash and investors responded to massive government stimulus drivers.

I do these “Scenarios & Probabilities” exercises, with both fundamental and technical drivers, for my TAZR Trader group all the time -- more so when big inflection points in earnings, rates, and volatility (fear and fear-of-missing-out) are on parade. 

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Good Investing,

Kevin Cook
Senior Stock Strategist

Kevin Cook, Senior Stock Strategist at Zacks, is a world-class expert in technical analysis and what makes markets move. He provides commentary and recommendations for the Zacks TAZR portfolio.

¹ The results listed above are not (or may not be) representative of the performance of all selections made by Zacks Investment Research's newsletter editors and may represent the partial close of a position.

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