Band Matt Wagner, CFA
As the S&P 500 flirts with bear market territory, headlines proclaim that a recession is priced in.
But how likely?
High-yield credit spreads, generally seen as a leading indicator of economic downturns, have risen 112 basis points since the start of the year.
ICE BofA US High Yield Index Option Adjusted Spread
If we look at S&P 500 valuations, the picture looks more favorable, even after a 14% decline from its peak. Admittedly, the risk of recession has increased, but it seems to us far from certain.
The current forward price-to-earnings (P/E) ratio on the S&P 500 (17.9 times) sits above its 20-year historical median of 16 times. Assuming a recession started with negative GDP growth in the first quarter and equities eclipsed the highest earnings of the cycle, one would expect a significantly lower index multiple.
For context, in the midst of the global financial crisis-induced recession, the average S&P 500 P/E ratio was well below 13 times.1
Moving down the size spectrum of US equities, valuations signal a much bleaker outlook.
At the end of 2019, before the Covid-19 pandemic, the S&P 500 was trading with a modest 11% P/E premium to the S&P 600.
Fast forward to May 2022 and the P/E on the S&P 500 is 17.9 times and the S&P 600 is 11.7 times, a valuation premium of around 50% for the bigs versus the smalls . Historically, the S&P 500 has traded at a median of 7% delivery to the S&P 600 on P/E.
Relative C/E multiples of the index: S&P 500/S&P 600
What seems clear to us is that investors expect the Federal Reserve’s challenge to pull off a “soft landing” for the U.S. economy to weigh more heavily on small-cap earnings than earnings. large caps. As a result, small cap valuations, relative to large caps, are more priced in to a headwind of recession.
For investors who a) are looking for attractive valuation opportunities and have a time horizon long enough to withstand normal fluctuations in the economic cycle, or b) who assume that a potential economic slowdown will be more moderate than valuations suggest, we suggest an overweight allocation to small caps.
Earnings Growth, Returns and P/E Multiples
At the bottom of the earnings forecast in July 2020, estimated earnings for the S&P 600 were down 50% from the end of 2019. Estimated earnings for the S&P 500 were much more resilient, down just 25%.
While most investors know how some tech giants have provided an earnings cushion for large-cap US stocks, fewer appreciate the sheer magnitude of the rebound in small-cap earnings.
Forward earnings estimates for the S&P 600 are now 87% higher than at the end of 2019 and well ahead of the 32% growth in the S&P 500.
Despite superior earnings growth, the S&P 600’s 21% return is lower than the S&P 500’s 28% return.
Index returns and EPS growth
Strong earnings growth pushed down multiples for both indices. The S&P 500 multiple of 17.9 times is about 10% above its median 20-year P/E multiple, but well below its 20-year peak of 23 times from July 2020.
The S&P 600 P/E ratio of 11.7 times represents a discount of more than 30% from its historical 20-year median P/E of 17 times.
The last time small cap earnings multiples were this low was during the lows of the global financial crisis in early 2009.
The valuation discount of small caps later in an economic cycle is not necessarily unexpected or unwarranted.
Small caps tend to have less diversified companies than large caps and are more geared towards economically sensitive sectors like financials, materials, industrials and consumer cyclicals, which tend to have more volatile earnings growth .
Nonetheless, the bleak small cap earnings outlook implied by valuations could set a low bar for small caps and investors to thrive.
Consider this excerpt from Abby Joseph Cohen, former senior investment strategist for Goldman Sachs and current professor at Columbia Business School, in a recent Financial Times opinion piece:
Valuations are much less extreme than they used to be and, in some cases, reflect rather gloomy entrenched expectations. Investing can be less difficult when the consensus outlook is sunny. But the best returns can come when a less cheerful scenario is reflected in security prices.2
Earnings growth trends at the sector level will be the subject of the next article in a three-part series on small cap valuations.
1 Using the December 2007 to June 2009 calendar for the Great Recession.
2 Abby Joseph Cohen, “Now is the time for stock pickers in the markets”, FinancialTimes05/24/22.
Originally published by WisdomTree on June 2, 2022.
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