Stock-market valuations are “historically extreme” by almost every measure. And while valuation corrections don’t necessarily result in market pullbacks, the risk of a “hard” correction is growing, warned a top Wall Street strategist.
“With the current cycle advancing very quickly, the risk that the correction is hard is growing,” wrote Binky Chadha, chief strategist at Deutsche Bank, in a Thursday note.
The warning comes as Wall Street firms have expressed nervousness as equities continue to rally, pushing major indexes to all-time highs, without any significant pullbacks. Including Friday, the S&P 500 has gone 214 trading days without a 5% pullback, rising more than 33% over that stretch. That’s the longest run without a pullback since a 404-day run that ended on Feb. 2, 2018, according to Dow Jones Market Data.
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Major indexes were on track to lose ground for the week Friday, with the S&P 500
SPX,
and Dow Jones Industrial Average
DJIA,
threatening to extend a losing streak to five sessions. The S&P 500 is down just 1% from a record close hit on Sept. 3 and has more than doubled from its March 2020 pandemic low.
Chadha noted that while equities are “very expensive,” that fact alone doesn’t require a large market correction. That’s because valuations can fall if rising stock prices are outpaced by earnings growth, shrinking the price-to-earnings ratio even as share prices rise.
Those types of soft valuation corrections are typically seen early in a recovery when earnings growth is rapid, he said. During this recovery, however, the “compression” in earnings multiples has been slow and uneven, Chadha observed.
Using trailing 12-month earnings, the price-to-earnings, or P/E, ratio for the S&P 500 moved from a low of 14 at the depths of the pandemic 27 at the start of 2021. It has subsequently compressed to 23.1, a decline of 14%, as earnings outpaced the rise in prices, but remains 15% above its historical range of 10 to 20, he noted.
Deutsche Bank
Multiples based on forward earnings estimates have been going sideways at an elevated level. Other ratios, such as enterprise value, or EV, relative to EBIT (earnings before interest and taxes) and EV/EBITDA (earnings before interest, taxes, depreciation and amortization) are down modestly from record highs but remain above their tech bubble peaks, Chadha said, while cash-flow…
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