Why 'buy the dip' is a fallacy: stocks are more expensive than they seem

London

TEMPTED by the cheap valuations the equity rout has produced? Think again: stocks may still be much more expensive than they seem.

The ratio of price to estimated earnings for the S&P 500 Index has fallen to 15.5 times, much lower than the dotcom era's 25.7 and almost the same as at the start of the bull market. Emerging-market stocks are similar: the benchmark gauge has fallen below its life-time average valuation and is also 30 per cent cheaper than its all-time high.

But stock prices discount known risks more quickly than analysts' estimates for earnings, which follow with a time lag. Indexes already reflect the latest reality, but profit forecasts don't yet. That means the current price-to-earnings ratios are logical fallacies.

In 2000, the S&P 500 peaked in March but profit projections kept going up until September. The delay was shorter in 2007, at 20 days, but sustained cuts to forecasts didn't begin until June 2008. For emerging markets, the lag was nine months in 2007-2008, 12 weeks in 2011, and three months in 2018.

So, when stocks are falling but earnings-per-share (EPS) estimates are yet to catch up, how do you evaluate the true worth of stocks?

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There may not be a foolproof method, but leaning on history is a sound proxy. We can estimate the extent by which analysts cut forecasts on an index during a significant rout driven by economic crises, and use that to calculate how low stocks must fall to reflect their average valuation. That would give investors a sense of how long they should wait before buying the dip.

In the slump that followed the bursting of the dotcom bubble 20 years ago, the US benchmark witnessed a reduction of 14.3 per cent to its EPS estimates. The 2008 financial crisis prompted a 39 per cent cut.

Let's take the smaller of the two cuts and assume analysts will prune their projections by the same degree this time round, especially because expectations for a recession are building up just as they were in 2000.

That would mean the average EPS estimate could go down from a peak of 178.54 points to 152.97 points. The average price-to-estimated earnings ratio for the index, based on available data for 30 years, is 15.84. That implies a target price of about 2,423, or 12 per cent lower than Wednesday's close, and suggests a potential buy-the-dip point.

The current price, expressed as a multiple of the lower assumed EPS, shows a hypothetical valuation of 17.9 times, a seventh higher than the apparent valuation. That's how costly US stock markets are now.

For the MSCI Emerging Markets Index, the valuation distortion is even deeper, given the higher volatility of EPS projections.

In 2008, analysts cut EPS estimates for the gauge by about 49 per cent. The reductions during the 2011-2015 slump (spurred by the euro-area debt crisis, taper tantrum and China slowdown) were about 40 per cent.

If the smaller reduction is applied to the present, the MSCI gauge may see estimates falling to 60.76 index points. Given its average valuation of 11.48 since 2005, this lower EPS represents an index price of 697 points.

That's a 23 per cent slump from current levels. Again, that may be considered the bottom for the market, according to this method.

If we apply the current price to the lowest possible valuation, the MSCI gauge has a hypothetical valuation of 14.9, a 37 per cent premium to the current valuation.

That can be seen as the degree of risk in buying emerging-market shares right now. BLOOMBERG