U.S. Equities Bounce, But What About the Overvaluation

Figure 1: S&P500 12mth Forward P/E Ratio and U.S. 10yr Real Bond Yield (%) 

Source: Datastream/Continuum Economics (using 10yr breakeven inflation for real bond yields)

The decline of 10yr U.S. Treasuries from 5% is bringing some relief for the battered U.S. equity market over the last week. Prospect from here depend on the economic, policy outlook and valuations. For the U.S., our view remains for a slowdown to below 1% quarterly growth into 2024 (here), which will build expectations that Fed easing can arrive by the summer and we see a cumulative 50bps of 2024 rate cuts and 100bps in 2025.This means the help from government bonds for the U.S. equity market is tempered, as 10yr yields will likely only come down marginally more to around 4.50% by end 2023, as then the inverted yield curve will restrain 10yr Treasury yields again.

Meanwhile, though a slowdown rather than recession could mean only small to modest reduction in corporate earnings expectations, Q4 corporate earnings estimates are already being trimmed. Indeed, our top down macro views of slow U.S. growth next year makes bottom up consensus of +12% 2024 EPS for the S&P500 look too optimistic.

In the meantime, the U.S. equity market is still left with overvaluation on traditional measures. The outright 12mth forward P/E ratio is modestly overvalued in itself (Figure 3). Additionally, against 10yr real bond yields U.S. equities appear overvalued.2003-06 saw similar real yields accompanied by 12mth forward P/E ratio in the 15-17 region (Figure 1).  Meanwhile, 2yr yields still significantly exceeded the S&P500 dividend yield (Figure 2) and the last time this happened in 2018 we had the sharp selloff at end 2018. In 2004-07, the excess of 2yr yields also sapped equity market valuation.

Figure 2: U.S. 2yr Treasury Yield-S&P 500 Dividend Yield (%) 

Source: Datastream/Continuum Economics 

Figure 3: S&P500 12mth Forward P/E Ratio (%) 

Source: Datastream/Continuum Economics 

Looking at 10yr nominal U.S. government yields versus the S&P500 12mth earnings yield (Figure 4) shows the narrowest gap since 2002. Finally, though the U.S. high yield spread versus Treasuries has narrowed in the last week, absolute high yield levels still exceed the S&P500 earnings yield (Figure 5).

Figure 4: S&P500 12mth Earnings Yield and 10yr U.S. Treasury Yield (%) 

Source: Datastream/Continuum Economics 

Figure 5: S&P500 12mth Forward Earnings Yield-U.S. High Yield (%) 

Source: Datastream/Continuum Economics 

The pessimists could argue that the equity market reset to an era of 4% plus 10yr yields has not been complete and that we should be at say a fifteen 12mth forward P/E ratio for the S&P500 is required given the overvaluation versus U.S. government bonds and high yield. With 2024 EPS at $246 this would point to 3700. With a 17 forward P/E ratio then the bears argue we could fall to circa 4200.  We would not be so pessimistic if the U.S. manage low growth rather than a recession, but it is an alternative downside scenario.   U.S. equity optimism over technology and AI is one supporting factor that could avoid a complete reset to where 10yr U.S. Treasury yields will settle. 

For now, the optimists could run the S&P500 to 4400 and potentially as far as 4600, but we would suspect we will have one more relapse as valuation are stretched and bad economic news could filter through quickly. We stick with a 4200 end 2023 forecast for the S&P500.A sustained recovery in the U.S. equity market really needs a sense that the Fed are close to starting easing the Fed Funds rate, both to firm up 2024 easing expectations and build 2025 easing speculation. Given the current Fed stance this all looks to be a H2 2024 story or spring at the earliest and is unlikely to occur in the next few months. When this occurs equity market sentiment would latch onto the Fed easing story and this could still produce a H2 2024 rally to 4800 by end 2024.