Expert warns of another 25% drop
- Shares have rebounded 12% since June 16.
- But they have more downsides to come, according to Bill Smead.
- Smead compared the current selloff to three past bear markets with similar attributes.
For Bill Smead, founder and CIO of Smead Capital Management, the current stock market selloff resembles some of the biggest bear markets of the past 60 years.
That’s bad news for investors, many of whom are hoping stocks have hit a sustainable low after climbing 12% since mid-June.
Smead, who started at bankrupt investment bank Drexel Burnham Lambert in 1980, said in a comment on Tuesday that he believed the S&P 500 “could easily” drop another 15-25%, which would mean a decline. peak to trough of up to 36%, putting the sell-off in the company of some famous market declines.
This is because there are three main qualities present in the current environment that were at play in the bear markets of 1968-1970 (-36%), 1973-1974 (-48.2%) and 2000-2003 (-40.1%).
The first is the euphoric mood that gripped investors after the March 2020 low into 2021. and the FAANGs – was “one of the most legendary episodes of stupidity of all time.”
Some investors still seem to be clinging to their optimism, but that’s a mistake, Smead said.
“Do you have to buy stocks because of their fall like people did in 2000-2003? A 75% drop from the peak makes a stock a value stock? A seven months cure the sins associated with the mania of the past five years? We don’t think so,” Smead wrote.
This is due to the fact stock market valuations remain too high. The S&P 500’s price-to-earnings ratio was 24 times earnings in January 2022. The historical average for the index is between 14 and 17. Stocks were historically expensive in all three market selloffs mentioned by Smead.
Then there is the presence of a hawkish Federal Reserve. Inflation is at its highest level since 1981 (9.1%) and the Fed is aggressively tightening its policy to calm it down. This bodes ill for corporate earnings and economic growth as the Fed hopes to rein in consumer demand. Pundits at many Wall Street firms like Goldman Sachs and Morgan Stanley warn that earnings expectations for the rest of the year and next need to come down further.
Finally, Smead pointed out that in the three previous selloffs mentioned, bear markets have extended for at least a year and a half from their highs. The peak of the current decline occurred seven months ago, on January 3.
“It seems history tells us that this bear market has more time to attract investors since the most similar prior bears have lasted at least 18 months,” Smead said. “The S&P 500 could easily pull another 15-25% off current prices as the Fed tightens credit and P/E ratios tighten.”
The bigger picture
Smead’s views on the market’s next direction match those of some of Wall Street’s top strategists.
Mike Wilson, Morgan Stanley’s chief U.S. equity strategist, said this week that stocks would fall another 20% if the U.S. economy slips into a recession. He said there will likely be less of a gap between when the Fed stops climbing and when the economy enters a recession.
“I think ultimately it will be a trap,” Wilson said.
Savita Subramanian, head of US equities and quantitative strategy at Bank of America, also made a similar prediction in July, calling for a recession and up to 20% more downside.
Subramanian said the bank’s derivatives team “believes equities don’t sufficiently price in a recession if we’re already in one.”
Still, these are worst-case scenarios for two strategists who are already among the most bearish on Wall Street. Subramanian’s target for the S&P 500 this year is 3,600 and Wilson’s is 3,900. Most strategists maintain targets above 4,000.
But again, with the Fed showing no signs that it will back down from its hawkish policy until inflation drops significantly, many are calling for downward revisions to earnings estimates.
Some, too, are calling for valuations to fall even further, despite the fact that the selloff so far has been driven entirely by valuations, not earnings.
Michael Lebowitz, portfolio manager at RIA Advisors, told Insider earlier this month that high inflation was correlated with a sustained decline in valuations.
The market’s cyclically-adjusted price-to-earnings ratio (CAPE) currently sits at 28, above the long-term average of 20, he said. When inflation was 9% in the past, the market CAPE ratio was usually between 5 and 15.
Lebowitz said he wouldn’t rule out the S&P 500 falling to 2,600.
The direction of stocks going forward appears to depend on the direction of inflation, the reaction of the Fed, and the reaction of the economy to both inflation and central bank policy.
The U.S. economy posted its second straight quarter of negative GDP growth in the second quarter, another sign that the economy is weakening amid Fed tightening and crippling inflation. But many believe inflation peaked in July as commodity prices fall and consumer spending remains positive year-on-year. The labor market also continues to make impressive gains and the unemployment rate is still at a historic low of 3.6%.
If inflation starts to fall significantly, the Fed could show signs of a dovish pivot in the second half. If not, equities are likely to have a tough time ahead as the Fed shows great determination to crush rising prices.
“They’re going to keep monetary policy tight, even if inflation peaks,” Desmond Lachman, senior fellow at the American Enterprise Institute and former deputy director of the International Monetary Fund, said in an interview with Insider this week. “They’re probably going to keep the brakes on because they don’t want to screw up inflation again.”
With that in mind, stocks could head where Smead thinks they will – further down the bear market path.