I have warned about excessive valuation before (see 2025 Outlook: Cautious But Not Bearish). The S&P 500 is trading at a forward P/E of 22, which is elevated by historical standards. On one hand, valuation isn’t highly predictive of returns over a one-year horizon. On the other hand, elevated P/E ratios lead to lower returns over a five-year time horizon.
In other words, valuations don’t matter until they matter. As investors look ahead into 2025 against a backdrop of a high P/E market, one key question is: “What’s the downside risk in the event of a bear market?”
A giddy backdrop
Callum Thomas of Topdown Charts highlighted the frothy nature of the market today. IBES is known for its compilation of analyst earnings estimates. In addition to the well-known consensus FY1 and FY2 EPS estimates, IBES also publishes a long-term EPS growth estimate. As the accompanying chart shows, long-term growth estimates have reached the giddy levels similar to the dot-com bubble top.
The combination of elevated P/E valuation and extremes in earnings growth expectations makes the U.S. equity market vulnerable to a setback.
Sources of vulnerability
What could make stock prices fall? What if the Magnificent Seven growth were to slow?
To be sure, the stock market is rationally exuberant owing to the earnings growth of the Magnificent Seven compared to the rest of the 493 stocks in the S&P 500 (see Equity Return Expectations Under an Alien Invasion). On the other hand, this makes the market highly vulnerable to Magnificent Seven earnings disappointment. At a minimum, the gap in earnings growth expectations between the Magnificent Seven and the S&P 493 is expected narrow in 2025.
In addition, the stock market isn’t cheap even outside of the Magnificent Seven. Combined P/E ratios are equally elevated outside of TMT (Technology-Media-Telecom).
From a top-down perspective, the emerging divergence between the U.S. Economic Surprise Index, which measures whether economic statistics are beating or missing expectations, and the 10-year Treasury yield is worrisome.
The divergence is especially concerning as the inflation expectation trade is heating up.
If inflation expectations rise and push up yields, it would put downward pressure on P/E ratios.
Estimating downside risk
As the Magnificent Seven is a source of major vulnerability for the S&P 500, here is one way of estimating downside risk. An analysis of the limited history of changes in peak and trough P/E ratios shows that the median tech P/Es fell from 29.5 to 13.1, which is over 50%, though that doesn’t represent actual price risk because earnings will rise during the bear market. Nevertheless, a ballpark estimate of price risk in technology stocks should the AI bubble burst would be about 50%.
As the Magnificent Seven represents about 32% of the weight of the S&P 500, this translates into about 15% downside risk for the overall index. The 15% downside is a minimum estimate, as the S&P 493 would likely decline as well. Assuming a lower beta in the S&P 493 during a price decline, we estimate bear market downside risk at 20–30% for the S&P 500.
Watching for bearish triggers
Despite my valuation concerns, I see no immediate bearish triggers for stock prices. High yield funding proxies, such as the junk bond spread plus a five-year Treasury yield, and actual junk bond yield levels (blue and red lines) are not showing signs of excessive funding stress. I consider junk bond funding a sensitive canary in the coalmine of equity fund costs, which needs to be closely monitored.
I am also keeping an eye on the Advance-Decline Line, which is showing a minor negative divergence against the S&P 500. Historically, A-D Line divergence have lasted for months before major tops of the market.
In conclusion, the U.S. equity is highly vulnerable because of overvaluation and excessive growth expectations, but valuation is not very predictive of returns over a one-year time horizon. I estimate downside risk on the S&P 500 in the 20–30% range in the event of a major bear market. Despite my concerns, I see no immediate bearish triggers for investors to adopt defensive positioning in their portfolios.
Hi Cam,
If there is a major pullback, then looking at the charts I would expect it to go down to the 5000 to 5200 level where there is strong support from the April/May pullback and the August plunge. From our most recent highs this would be about a 14 to 17% pullback. To go much past this would be a bear market of “COVID proportions” which seems unrealistic at this stage unless there is some major unknown catalyst like COVID.
Another way I look at this is to look at the weekly SP500 chart and draw a channel around it since the 2009 bear market. The top of the channel goes along the top of the data and the bottom parallel line goes through the bottom of the 2018/19 low, the approx Oct 2022 low and the Nov 2023 low . To me this is the expected channel we will move in unless something major happens.
Assuming we don’t go straight down then a sizeable pullback would also bring us to the bottom of this channel at approx. SP-500 => 5000 which is at the support indicated above.
If we do go “straight down” then we come to the current “lower channel” support is at approx. 4750 which corresponds to the 2022 high which should also act as support.
When was the buy signal posted?