With the S&P 500 down -18% for the YTD period (Jan – May 2022), the question is how much lower will the market drop until it reaches fair market value? Maybe we are already at a bottom? While comparing the market’s price/earnings ratio (P/E) to historical averages is a good place to start, it is not a perfect method because of differences between interest rates and earnings growth prospects. Having said that, we can see that the median P/E since 1900 has been 16x vs. the current 18x level. Notably, the average P/E since 2000 (a low interest rate environment) has been much higher at 22x. In any case, we must wrestle with the key question: how will S&P 500 earnings perform over the next 12 months given huge unknowns around inflation, the supply chain and consumer strength. What if earnings declined -5% over the next 12 months to a 205 annual rate and the P/E declined to 16x (the historical average)? This would bring the S&P 500 to 3,280 (a further -16% drop from here). If earnings are flat and the P/E drops to only 17x, the S&P 500 index would find itself at 3,665 (-6.5% from here).
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