Image source: Pixabay

The market fell by 9% this week, which was the worst weekly drop since the height of the COVID-19 pandemic. The trade “solution” was a disaster. If left unchecked, this has the potential to do some real damage.

But valuations are now getting closer to their long-term averages. Dividend yields are at a 12-month high, and the equity risk premium is at a two-year high.

(Click on image to enlarge)

Last month, as it became evident to me that trade policy no longer appeared to be “negotiating tactics,” the probability of a valuation reset was rising. That meant a drop to the 4600 level in the S&P 500.

As we rolled over to a new quarter, forward EPS estimates rose to $278.96 on Friday. The long-term average forward PE is 17x (as shown by the red line on the above chart) according to my calculations. So, 17x recent EPS estimates gives us a “valuation reset” of 4750 on the S&P 500. That is still another 6% lower.

(Click on image to enlarge)

Trailing EPS, or earnings that have already been reported over the last 12 months, came to $248.66 as of Friday. And the historical average trailing PE is at 18.6x. So, 18.6x recently reported EPS of $248.66 gives us a “valuation reset” target of 4632. That is about 8.7% lower.

(Click on image to enlarge)

Interest rates have fallen from as high as 4.8% this year to 3.99% at Friday's close. As a result, the equity risk premium (or S&P 500 earnings yield minus Treasury rates) is back in positive territory and at a two-year high.

(Click on image to enlarge)

The dividend yield rose to 1.47%, which still isn’t great but is a 12-month high.

(Click on image to enlarge)

Along with the valuation reset targets I mentioned (between the levels of 4632 and 4750), I’ll be watching for a spike in the VIX to take out last July’s high of 65, possibly signaling a capitulation.

The problem with this analysis is that it doesn’t take into account the probabilities of a more-than-mild recession that may result if these trade policies do not get redacted. Valuations may reset back to average, but if earnings drop 10%+ on top of that -- well, lets hope we don’t have to find out.

More By This Author: