At 19x the S&P 500’s 12-month forward-P/E is among the most expensive in the last nearly 40 years. But it looks even more expensive when we look at consumer sentiment.
Based on consumer sentiment, the S&P 500’s P/E should be at 11x. If that was the case, the S&P 500 would be trading around 40% below today’s level, at around 2,700. In this article we look at what’s driving this massive dislocation and what it means for stocks.
Why is Consumer Sentiment So Depressed?
Consumer sentiment is at one of the weakest readings in 40+ years, even while the labor market is about the strongest it’s been over that timeframe. [1] Why are consumers so down?
- They’ve been worried about losing their jobs after the Fed started raising rates
- The big cushion from pandemic savings have run out
- Today’s price level is higher compared to pre-pandemic times (i.e., lower affordability)
We’ll look at some of these next.
The savings built up during the pandemic were massive, rivaling those seen during WWII as we pointed out last year. That helped support spending despite inflation souring consumers’ moods.
But those savings were spent very quickly:
- Excess savings are seeing a “boom-bust” development compared to other recessions
- Credit card spending is collapsing, falling below pre-pandemic levels
Without big savings to rely on any longer, the consumer is, once again, vulnerable to the next crisis.
Consumers are also upset that affordability has gone down. Even while the inflation rate has slowed, they’re upset that the price level today is higher than it was before Covid.
The poster child of unaffordability is the housing market:
- Consumers are reporting the worse buying conditions for houses in 60+ years
- Conditions are at levels that are strongly associated with recessions
- That’s the result of rising mortgage rates and house prices
What Does Weak Consumer Sentiment Mean for Stocks?
Consumer sentiment is already at recessionary levels. With excess savings gone, we believe deterioration in consumer spending may lead to rising unemployment.
If jobless claims rise, it’ll lead the equity market lower. Typically, peaks in the S&P 500 are made when jobless claims begin to accelerate ahead of a recession.
How bad could the labor market get? We can use the NAHB/Wells Fargo Housing Market Index as a leading indicator:
- Housing market weakness implies a rise in the unemployment rate to 7.4% by June 2024
- That’s a 3 pp. rise from today’s level
- A rise of that magnitude over that timeframe has always been associated with recessions
If falling interest rates lead to a strong rebound in housing market activity, investors may “see through” any rise in the unemployment rate as short-lived. That may boost valuations.
We’ll be watching the S&P 500’s reaction to the labor market data coming out this week. As we’ve been highlighting in our Weekly Asset Ratings, the technical setup looks bullish today:
- Year-end seasonality remains favorable over the next 8 weeks
- Breadth has been expanding, with the share of stocks above their 200-DMA approaching 70%
- Price is consolidating around a key level of resistance
A deterioration in the labor market could be reflected in the S&P 500 moving back below the price channel. That would be a signal we’d pay attention to in assessing a potential inflection point.
Conclusion: Stocks’ Window of Opportunity is Closing
The stock market rally we’re witnessing is typical following Fed pauses. Valuations rise as investors anticipate that easing financial conditions will boost earnings until the recession comes.
The entire move higher in Tech this year, for example, has been driven valuation expansion.
Fed pauses create a window of opportunity for stocks to move higher. The duration of that window can vary, though:
- It could last a while: in 1989 it took 14 months before the market peaked ahead of the 1990/1991 recession
- But could also be very short-lived: in 2000 the market peaked only 2 months after the Fed’s pause
- In 1995 no recession was seen after the pause, so the market kept moving higher
Heading into 2023, our target for the S&P 500’s “window of opportunity” rally was 5,200. However, the bank runs in March 2023 and the potential credit crunch led us to turn bearish too early.
What does the window of opportunity look like today? We believe that valuation upside is limited given the potential for the labor market to deteriorate due to a weak housing market.
We also expect Tech to provide less of a boost to the market’s P/E going forward:
- Weakening fundamentals: revenue growth is slowing due to a deceleration in capital spending on Tech
- Disconnect from real yields: Tech’s P/Es remain much higher than warranted by the level of real yields
While we’re not constructive on Tech, you should keep in mind that valuations could keep rising against our expectations.
For example, we’ve yet to see Tech valuations relative to the S&P 500 rise to the extreme levels seen during the Dot-Com bust. Euphoria around AI could be a catalyst driving valuation upside.
Could Fed rate cuts boost valuations? We believe they may not. Rate cuts may end up boosting demand too much, which could reignite inflation.
That’d be similar to the “stop-and-go” inflation regime of the 1970s, where inflation came in waves. It’d increase inflation volatility and make the business cycle less predictable.
High-inflation episodes like those in the early-1910s, 1940s, early-1950s, 1970s and early-1980s were associated with lower valuations. A resurgence of inflation would likely bring lower P/Es.
We continue to find the S&P 500 overvalued with an unattractive risk-reward, and prefer to be invested in other assets that:
- Are significantly undervalued relative to the S&P 500 like Ethereum
- Stand to outperform in the event rates fall with/without a recession like GLD, SLV, GDX and TLT
- Are uncorrelated to U.S. equities like TUR and Copper
On a side note, we’ll be posting the upcoming Weekly Asset Ratings over the weekend to cover any impact from Friday’s payrolls number on the ratings. That’s a change from earlier this week when we had mentioned that we’d be posting it on Thursday leading up to the release of the payrolls number.
Footnotes
[1] We’re using the University of Michigan Consumer Sentiment Index here.