Market handicappers see another 5% to 8% downside if key level for the S&P 500 fails

Published Sat, May 7 20228:12 AM EDT

Four months into a hazardous market retrenchment marked by trap-door declines, thwarted rallies, squeezed financial conditions and unhappy endings for many dozens of "story stocks," investor attention has turned decisively toward quantifying the risk rather than projecting quick reward. Take this collective shift of focus for what you will, either timely warning, or prudent reminder to stress-test a portfolio, or contrarian signal that the 15% S & P 500 downturn is running its course. Whatever the inference, it's noteworthy that so many market handicappers and strategists using distinct methods are coalescing around similar estimates of further downside risk to the index if the current trading-range low near 4100 fails: the zone from 3800 to 3900, another 5 to 8% down from here. The assessments of downside risk clustered around these levels are coming from multiple technical disciplines, fundamental approaches to calculating fair value and the historical record of deep corrections. Technicals The technical setup is pretty delicate with the S & P and all other key indexes in pretty defined downtrends under the major moving averages, the heaviest-weighted stocks in the benchmarks underperforming and resistance stacked above left by previous plateaus and recent failed rallies. While there is no unanimity among chart watchers — JP Morgan's Jason Hunter has been arguing for months and reiterated last week that he sees the 4100-4300 support band holding up as a new base — plenty are eyeing that 3800-3900 area as a potential destination. This is where the line marking the volume-weighted average price of the index from the March 2020 crash low sits, for one thing. Technical strategist Jonathan Krinsky of BTIG has for some time been expecting the S & P 500 to crack below 4000 before this correction is complete. He points to 3900 or just above as a place where some of the heaviest trading volumes have been concentrated in recent years, another way of divining a level where real-money demand might await. And, for adherents of the ancient Fibonacci indicators focused on specific ratios, a 38.2% retracement of the March 2020 rally to the January 2022 highs also would place the S & P just a bit above 3800. This is also almost exactly 1,000 S & P points down from the peak, just for fun. Valuation The main project of the market this year has been reeling in equity valuations from historically rich levels in a time of higher inflation, Federal Reserve tightening, slowing profit growth and fiscal contraction. This has disproportionately hit the biggest growth stocks granted a heady premium for their profitable dominance and the flimsiest loss-making upstarts with the highest story-to-substance ratios. Much work has been done along this front. The S & P 500 traded at 22-times forecast earnings ten months ago and last week fell to 17.5-times. Bounces this year have emerged somewhere around an 18 multiple, not far below the pre-pandemic peak, though it's hard to assume this will continue to be the case. With Treasury yields rising — capturing fears both of tenacious inflation and what the Fed might have to do to tame it — estimates of fair value for equities get pinched. This chart shows the equity risk premium, the difference between the S & P 500's earnings yield and the 10-year Treasury yield. As the line drops, the valuation cushion becomes compressed and stocks relatively more expensive. The indicator is down near its lowest levels of the post-2000 period with the S & P earnings yield around 5.6% and the 10-year Treasury now above 3.1%, for a spread of 250 basis points (2.5 percentage points). A return to a more typical spread of 300 basis points would argue for a forward S & P P/E near 16.5. On currently projected earnings, it gets you to a bit above 3800. This is how Morgan Stanley strategist Mike Wilson has set his longstanding target level for an eventual low for this correction. Fidelity Investments Director of Global Macro Jurrien Timmer takes a similar route to about the same place, citing the historical relationship between valuation and the two-year Treasury yield, producing a slightly lower "fair" P/E. Keep in mind these models are only as good as the earnings outcomes and also that future profit growth can do some of the work in conjunction with any decline in share prices. History One of the top-of-mind possible precedents for what the markets are undergoing is the 2018 experience: An early-year momentum peak followed by a sharp, quick correction, a rally back to a slight new high led by defensive sectors, all while the Fed tightened and 10-year Treasuries ventured above 3% for the first time in years. Months of chop near the down-10% level followed until Chair Jerome Powell's comments about Fed tightening being on autopilot was taken as an excuse for a headlong selloff through December of that year. The S & P 500 ultimately sank a bit more than 19% from high to low on a closing basis. And, in fact, the market has logged four declines of between 19% and 20% in the past few decades — a statistically unlikely frequency of drops culminating at exactly that level of loss. These were in 1990, 1998, 2011 and 2018. Only 1990 was associated with a recession, a fairly shallow and brief one at that. Call it coincidence, call it a collective limit order placed by investors when the economy is seen as muddling through. A 19% to 20% decline from the January peak above 4800 would take the S & P between 3850 and 3900. This all might seem like aggregated anecdote, fluky happenstance and spurious superstition. Yet for what it's worth, Leuthold Group shows that when an S & P 500 drop has gone past that 19% loss level, it has tended to overshoot lower by a lot and not a little, though the sample since 1990 has been the 2000-'02 tech wreck bear market, the 2008-'09 financial crisis and the 2020 Covid crash. Leuthold CIO Doug Ramsey, cautious on the market for a good while before the peak, last week wrote, "In the face of the shellackings in the Nasdaq Composite and Russell 2000 (both -23% through May 5), the S & P 500 is doing what we sometimes suspect it was designed to do: Conceal the bear's damage until it's almost too late to take action." Can't dismiss this prospect, though of course no one, neither bull nor bear, knows with any certainty where the market is ultimately headed or what route it will take to get there. While the above multitude of approaches arrives at 3800 to 3900 as a plausible place the market might visit, it's also true that it might never get there or slice right through. And naturally, bounces can emerge at any moment that could change moods and minds. For now, it's still a damaging but not atypical correction, multi-quarter choppiness not unusual later in a market cycle. The frothiest parts of the market have been smoked pretty comprehensively, valuation risk has been trimmed, investor positioning has turned defensive and assets are some good distance toward pricing in a plausible Fed path. It still doesn't hurt to stress-test one's portfolio and psyche for the chance that the number crunchers and chart watchers are right about the risk of another 5% to 8% setback from here.

Traders on the floor of the NYSE, May 6, 2022.

Source: NYSE