As we’ve seen over the past three years, stock investors don’t like recessions, not even the no-shows. There was much anxiety about an imminent recession from January 3, 2022 through October 12, 2022, as reflected by the 25.4% drop in the S&P 500 over that period.
That was a 29.5% drop that was only partially offset by the 5.8% increase in forward earnings. The result was a P/E-led bear market.Yet, the latest one bottomed at a relatively high forward P/E because investors started to anticipate that recession fears might start to abate, as the economy proved remarkably resilient in the face of the significant tightening of monetary policy from March 2022 through August 2023.
In our opinion, the key driver of the forward P/E is investors’ perception of how much and for how long earnings can grow before the next recession depresses earnings and the valuation multiple. Economic growth drives earnings growth, and investors’ expectations for both drive the forward P/E. So now what? The Fed has been cutting the federal funds rate since September 18. That certainly reduces the risk of a recession caused by the tightening of credit conditions and increases the odds of a long expansion.
It bottomed at 20.5 during Q3-2022, above its historical average. It’s not a useful valuation measure, though, since it tends to soar during recessions as earnings fall faster than stock prices.. Many years ago, Warren Buffett mentioned that he likes to follow the ratio of the total value of US corporate equities at market value divided by nominal GDP. The Buffett Ratio rose to a record-high 2.96 during Q2-2024.It rose to a record 2.99 during the final week of November.