Is it a good time to buy? | Stock Market 2022 Crash

Typically I talk about equity specific valuations, but today I'll take a look at the market valuation (as a whole) to answer the ultimate question, "is it a good time to buy?" I went through more than 60+ years of stock market data to help answer this question.

We're going to focus on discussion on the fair value of the S&P 500 (SPX) index as a proxy for market valuations.

What is fair value?

Keeping it simple,  the fair value of the S&P can be calculated based on just two things: the market or equity risk premium (ERP) and forward earnings yields. From those, we can determine a fair price/earnings (P/E) multiple we'd be willing to pay, which gives us our fair value.

Given how drastically the Fed has changed its monetary policy this year, it's fair to say this is driving much of the reduction in valuations.

So, let's go ahead and calculate those two things...

Market Risk Premium (MRP)

The market risk premium (MRP) is the difference between the expected return on a market portfolio and the risk-free rate – often measured using U.S. T-bills or the 2-year Treasury rate (assuming the US government doesn't default on its debt).

Historically, however risk premiums have had huge variances due to the economic boom and bust cycles, which stocks valuations are always trying to be ahead of. So, in practice have been estimated to be as high as 12% and as low as 1%.

In general, the higher the risk premium, the more you are being compensated for holding stocks.

In order to calculate the compensation today, we have something called the implied market risk premium.

You can compute the IERP yourself, which you can learn to from Aswath Damodaran's lecture and resources. I was also able to find another site for the real-time chart which corroborated with Aswath's calculations for the historic periods in his lecture (you're welcome). So, it can be accurately relied upon.

However, after making some updates to Aswath's model (i.e. updating for the Fed projected terminal rate of 4.5%), I personally get a fair value of the SPX (assuming a 5% ERP) of $3521 and an IERP of 4.8%.

Earnings/Dividend/Buyback Yield

As you can see from the model, it's still forecasting earnings growth over the next five years. If we do have a minor recession next year, this can still hold. However, the case for a steep recession is not priced in here – so, that's a risk that you need to keep in mind, as it's impossible to predict.

However, if we do see earnings yield minus real bond yields approach zero, I'm running for the exits with all my chips – as anyone should have done in 2000. I'm not sure if that ever happens again, tbh, since after 2000 we entered a completely different era of monetary policy. The Fed's Stock Valuation model, coined by Yardeni, might not be as relevant anymore. However, I'll keep an eye on it.

But, what if recession?

However, if we do get an inversion on the 3mo/10yr yield curve, we are more likely to get that recession based on history. I personally think it's just a matter of time, and I'm hedged by not going all-in here.

IMHO, there is no deep recession price in... which keeps me cautious. On top of that the ERP of being in the market here isn't all that attractive based on recent history. But, for my long-term portfolio, I will continue to DCA in companies that I believe I can hold for the next 10 years. For those companies, we are currently in a generational buying opportunity, imo.

Other Models

As with any model, there are limitations and risks... and you should never rely on just one. My conclusion, based on calculating fair value and implied ERP, is that we are fairly valued assuming a "softish" landing.

So, what do other models suggest?

S&P vs Interest Rates

The ERP is, in theory, irrespective of rates, but with rising rates there are legitimate alternative to stocks are real rates rise. And hence, there is a correlation to S&P value and 10Y Treasury rates. Currently, that correlation indicates we are at fair value, however in times of crisis, we can see that we can go lower.

However, we have to remember that there are other variables now outside of rates, including the Fed balance sheet runoff and quantitative tightening (QT). That's likely another headwind, which we don't have much history to really take from.

Concluding Thoughts

Based on looking at several metrics, my conclusion is this... I don't know what happens to the economy, but if we do see a "softish" landing with earnings compression over the next two quarters and recovery in 2023, then we are fairly valued and this is the time to start accumulating. However, if we are due for a sharp economic contraction, which I can't rule out... in fact, I think the likelihood is pretty high, then I'd still remain cautious her because we have not a crisis level in valuations.

On top of all this, we'd have to keep in mind that the required rate of return with real yields being higher are also higher. So, given the terminal fed fund rate at 4.5% and ERP of let's say another 5%... we need at least 9.5% CAGR in our equity portfolio, which you might be able to do... but I believe you'd have to be selective and the index might not be the place to go or hide (yet).

There might now be a a clear sector or strategy that wins here (i.e. growth or value) – at least not to me – but, I will do my best to really focus and research the companies I feel strongly about for the next decade.

If you're interested in what I'm doing, stay posted :) Happy investing and all the best!