As of Thursdays close the S&P 500 is down 7.21% in the month of March and we are only half way through. At this level we are already at the 3rd worst March performance since 1958. But for those looking for silver linings I offer the above chart.

Here we see the top 5 worst March’s since 1958 (plus this years although its not over yet). Yet 4 of the 5 went on to close higher over the remaining 9 months of the year, with an average return of 21.3%. The only outlier was 2001, after the horrific tragedy of 9-11.

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So does that mean its safe to buy stocks?

Corporate bonds spreads usually signal underlying stress in the system but so far they haven’t spiked. Although they are starting to slow inch higher. It’s something to keep a close eye on.

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But unfortunately I don’t believe we have seen the worst yet. Here is my reason:

I’ve always talked about the 3 pillars of fundamental analysis.

1. Earnings growth
2. Economy (recession probabilities)
3. Valuation

Lets tackle number 3 (valuations) first. I’ve discussed numerous times over the last few months how valuations are no longer favorable to stocks now that interest rates have risen so sharply. The first chart above shows the earnings yield (EPS divided by price) on the S&P 500 compared to the interest rate on 10 year treasury bonds.

For the first time in at least 20 years, the interest rate in bonds is higher or equal to stocks. Since stocks are far more volatile than bonds, stocks are only favorable when they offer higher rates to compensate for the added volatility.

The bottom chart above shows it another way. Earnings yield minus bond yields. Which has gone negative.

So the valuation pillar has been kicked out.

That’s not bad by itself. After all everyone knows valuations are not a timing tool. But it also means that there is more weight to bear for the economy and earnings pillars. Earnings were beating estimates by double digits then everything is OK.

But something changed. If the administration really means business than the economy and earnings pillars won’t be able to shoulder the weight any longer. We can be confident that corporate America will adapt to whatever comes its way eventually. But in the short term, it could be painful.

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So then what happens?

I preface everything that I am about to write with this is only calculated speculation on my part. My guess is as good as yours.

However in the past when markets need to reset they have fallen back to their average valuations. The above two charts shows forward PE (PE based on expected EPS over the next 12 months) and trailing PE (reported EPS over the last 12 months). On each chart the red line is the moving average valuation over the last 15 years.

Since the breakout to new bull market highs in 2013, every time we had a calamity in the markets. Valuations reverted to their historical averages before finding support.

For example, 2015 we had the China currency devaluation scare, 2018 we had the Fed overtightening and “Christmas crash”, in 2020 we had COVID, and 2022 we had the inflation scare.

Average PE’s now are 17x for forward PE and 18.6x for TTM PE. That would give us an S&P 500 target of 4600 to reset valuations again.

During normal times I only look at forward PE because its all about how earnings results come in relative to expectations. But during times I stress, I revert to TTM PE’s because if the economy weakens then earnings estimates will need to be revised down. Which can obviously throw off the Forward PE calculation.

But in both cases a fall to average PE’s come out to S&P 500 4600. That’s still about 16% lower than Thursdays close.

I have a feeling that is where we may be headed unless compromises are reached on the policy front.

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