Stocks Won't Look 'Cheap' For Very Long

A lesson in Wall Street's earnings game... Stocks won't look 'cheap' for very long... Pro analysts are slow to react to everything... How bear markets can keep going... It could be a cruel summer... Kevin O'Leary's new show with us...

Don't be fooled. Some stocks may look 'cheap' – for now...

The more stock prices fall, the more people want to know when they will stop tumbling.

We're also interested, of course. That's mainly because when it happens, it will mark a great time to "back up the truck" and buy high-quality stocks at cheap prices again. It will be much like other market bottoms throughout history, like the panic of March 2020.

But we're not there yet.

That's the latest message from our colleague and Stansberry NewsWire editor C. Scott Garliss...

Even considering today's rally, Wall Street's forward 12-month price-to-earnings (P/E) multiple sits near 16.8 times analyst estimates. That's a hair below the 10-year average. And it's not far above the 25-year average.

In other words, as Scott explained on Friday in our free NewsWire service...

That number may look cheap, and you may hear people tell you this makes it a good time to load up on cheap stocks. Be careful!

The problem is estimates need to go lower... and when that happens, then the real carnage will set in.

As longtime Digest readers know, before joining Stansberry Research in 2017, Scott spent 20 years trading on Wall Street. He worked for some of the top investment banks in the country, including First Union and Wachovia Securities.

And as I (Corey McLaughlin) can tell you from working closely with Scott over the past few years, he knows the ins and outs of how institutions and Wall Street analysts value stocks better than most folks.

So when Scott alerts us to a narrative in the markets that doesn't sit well with him, it's worth listening to his perspective...

Today, once-popular stocks like Zoom Video Communications (ZM) and Coinbase (COIN) are down as much as 80% from their previous highs... the major U.S. indexes are either in or near conventional bear market territory (down 20% or more)... and you might be hearing more chatter from the mainstream media about stocks being "cheap."

After all, an increasing number of folks in the investment world – eager for a turnaround in what's now one of the worst two-month performances for U.S. stocks in the past 100 years – are sniffing around. And they're hoping to smell any whiff of a market "bottom"...

Scott says to be careful bottom hunting...

What looks cheap now could look "expensive" in the months ahead after another corporate earnings season arrives. As Scott wrote in the NewsWire...

The thing you need to remember about Wall Street analysts... They're slow to react to everything.

Specifically, he says when Wall Street analysts cut their earnings estimates later this year – as Scott expects they will – P/E multiples will explode. In turn, that will make the stock market look expensive again...

And when that happens...

It will set off another round of selling to drive the multiple back to a "fair value level," Scott says. This is essentially the same story we wrote about in the March 10 Digest, when we said...

The threat of higher costs combined with slower growth... given the Federal Reserve's plans to raise interest rates... could cause market analysts to reduce revenue and earnings estimates across the board.

Then selling ‒ because of lower expectations compared with current valuations ‒ could beget selling... This is one way bear markets happen...

And much like the way this earnings game played out is one way a bear market can get started... it's also a big reason why it can continue.

Let's turn things over to Scott to explain the rest of the story in his own words...

Over the past couple years, this occurred in the opposite direction... When growth was exploding higher, analysts were slow to raise their estimates. According to financial-data firm FactSet, estimates at the start of quarters tended to undershoot the reported numbers by 5%.

Here's another detail to keep in mind...

Quite often over the past two years, Wall Street raised consensus estimates coming into quarterly reports, yet they still wound up too low after the real numbers were reported. As an example, look at the first quarter of 2021...

At the end of 2020, analysts predicted earnings growth of 15.8%. But just before companies prepared to release results in April, those same estimates predicted a 24.5% expansion. And by the time it was all over, earnings rose 48.3%, according to Yardeni Research.

It's an important lesson from Wall Street...

One of the things you learn after working on Wall Street for 20-plus years is that companies quickly deliver good news... and slowly deliver bad news. After all, their stock prices tend to go up on good news and fall on bad news.

So when management teams report first-quarter earnings, they'll be slow to lower guidance for the full year.

In the minds of Corporate America, it's hard to base a trend on what's happening in the first quarter. And by the time a company reports that quarter's earnings, it's only halfway through the second quarter.

In other words, in these folks' minds, there's still a lot of the year left for things to turn around and improve. So if things are bad, they can wait.

However, when the company reports second-quarter earnings, the picture has changed. At that point, corporate management is well into its third quarter.

Said another way... more than half of the year's production is done and dusted. At that point, these folks have a fairly good idea of what the year will look like.

But the thing is, second-quarter earnings reports don't officially get underway until banking giant JPMorgan Chase (JPM) reports on July 14. And the season ends with Disney (DIS) on August 12.

That's when we'll really see companies start to take down their earnings guidance.

But hasn't the first quarter been bad enough already?

Right now, you could possibly be thinking, "What about the guidance out of Walmart (WMT) and Target (TGT) last week?"

Yes, the two big retailers lowered their guidance. But importantly, they report much later in the quarter than most other companies in the S&P 500 Index.

As a result, they have a better look into whether the trend is decelerating or accelerating as the year progresses. And they told us... it's getting worse.

On the front end of this past earnings season, most management teams talked up costs but tried to remain positive about their businesses. Like I said before, they want to be optimistic in hopes of the situation improving.

But the reality is... it's not.

So where does this leave us today?

We must always remember that money managers are investing for what the economy will look like in 10 to 12 months...

Expectations of a slower growth environment warrant a lower "multiple" on the S&P 500.

According to FactSet data, the 20-year P/E average for the S&P 500 is 15.5 times. In other words, even without earnings-estimate reductions... the stock market is expensive right now.

So just based on that math, the S&P 500 should be closer to the 3,640 level if the expectation for roughly 17% earnings growth proves right. But based on the fuel and labor costs we've heard about so far, profitability is rapidly declining.

This dynamic tells us the S&P 500 needs to drop further for money managers and institutional investors to get more excited about valuations.

The way I (Scott) see it, a strong case can be made for the pre-pandemic high of around 3,400 – or 15% lower – as a major level of technical support for the S&P 500, as stimulus-driven demand comes out of analysts' estimates... and a slower-growth, higher-inflation environment comes in...

Eventually.

Finishing up...

This is Corey again. As you can see, there's a compelling case for lower stock prices ahead, broadly speaking, based on the dynamic that Scott described...

Another valuation indicator for the S&P 500 that we've mentioned before, the Shiller P/E Index, shows that levels are still historically high...

This metric, named after the Yale economics professor who invented it, measures data as far back as the 1880s. It's based on the average inflation-adjusted earnings from the previous 10 years.

It's also referred to as the "cyclically adjusted price-to-earnings ratio" (CAPE). And its average reading, stretching back more than 200 years, is closer to 17 times earnings.

Today, it checks in at 31 times earnings. That means stocks are still very expensive according to this indicator.

As regular readers also know, Scott isn't the only one warning that this year's sell-off isn't done yet...

For different reasons, our colleague and Ten Stock Trader editor Greg Diamond has been hammering the point to his subscribers as well. But as Greg explained in a Q&A last Monday, he doesn't necessarily care about the "why"...

It could be Wall Street analysts finally lowering their earnings estimates, or it could not. They will play a part one way or another. But as a technical analyst, Greg focuses mainly on price and time... and how stock prices behave around key dates or "inflection points" in the markets.

In fact, Greg says one of these important dates is just two days from now... And he expects it to be an "aftershock" to the sell-off that caught a lot of people off guard to begin the year.

So when we combine what Greg's saying and what Scott's thinking, the timing might be slightly different. But there isn't much difference, especially if you're a long-term investor.

And importantly, we hear the same message from both of them...

Don't be fooled. Stocks can go lower from here.

Kevin O'Leary: Wait for This Major Blowup

In the first episode of a new monthly series with our editor-at-large Daniela Cambone, "Shark Tank" star Kevin O'Leary agrees with Scott and Greg that the market hasn't bottomed yet. But when it does, you'll want to be ready to put new money to work...

Click here to watch this video right now. For more free video content, subscribe to our Stansberry Research YouTube channel... and don't forget to follow us on Facebook, Instagram, LinkedIn, and Twitter.

New 52-week highs (as of 5/20/22): None.

In today's mailbag, feedback on Greg Diamond's Masters Series essay from Sunday... and more thoughts about "real world" inflation. Do you have a comment or question? As always, e-mail us at feedback@stansberryresearch.com.

"I am writing in response to the Sunday May 22 Masters Series article by Greg Diamond, titled 'From Stocks to Silver... Let's Review How Bad It Can Get.'

"I get so much correspondence from Stansberry that I must admit that perhaps I don't pay as much attention to it as I should. This morning I sat down with my first cup of coffee and gave this one my full attention; and am very glad I did. This article is fantastic!

"Thank you Greg." – Paid-up subscriber William O.

"The idea that inflation is only 8.5% is a false statement and the biggest myth sold today to the American citizens and in the financial world. In reality, all one has to do to get a true picture of inflation's impact on themselves is sit down, look at the following expenses that an average person has to deal with and compare them to what they were last year at this time.

"1. Has real estate only gone up 8.5%? A resounding no.

"2. Have utilities such as gas, electricity, waste disposal and water only gone up 8.5%? More than likely no.

"3. Has your grocery bill only gone up 8.5%? A resounding no.

"4. Has gas, maintenance and repair costs for your vehicle only gone up 8.5%? A resounding no.

"5. Has health, vehicle and homeowners insurance and related costs only gone up 8.5%? A resounding no.

"6. Has rent for those who cannot afford the exorbitant new home prices only gone up 8.5%? Another resounding no.

"7. Have other consumer staples only gone up 8.5%? More than likely no.

"8. Have big ticket items, i.e. vehicles, appliances, furniture, etc., only gone up 8.5%? Another resounding No.

"9. Has airfare and vacation expenses only increased 8.5%. Another resounding No.

"I could go on, but when you go through this exercise, clearly inflation for the average American is at a much higher rate than 8.5%. I know my living expenses have increased far greater than 8.5%." – Paid-up subscriber Larry H.

All the best,

Corey McLaughlin with C. Scott Garliss
Baltimore, Maryland
May 23, 2022