If everyone is bearish on the market, why is the P/E ratio of the S&P 500 still at 20 times?

Two weeks ago, Savita Subramanian, chief strategy analyst at Bank of America, one of the major short sellers in the US stock market, finally gave in and raised her year-end target for the S&P 500 from 4,000 to 4,300.

One important factor that led Subramanian to abandon her long-standing bearish view was that many clients had been asking Bank of America:

If the market sentiment is really so negative, and if everyone is selling US stocks, why is the P/E ratio of the S&P 500 still maintaining at 20 times?

Subramanian said that from most indicators, US stocks are indeed statistically overvalued. In fact, according to her assessment, 18 of the 20 indicators for US stocks are overvalued, and only free cash flow and earnings per share standardized by historical levels are not overvalued due to pessimistic capital expenditure expectations.

Subramanian said that the profit decline of US stocks has been continuing for several quarters, and EPS is expected to bottom out in the third quarter of this year. Of course, when the earnings of listed companies decline, the P/E ratio will rise.

Therefore, Subramanian believes that in the market sentiment of "everyone is bearish", why can US stocks still maintain a P/E ratio of 20 times? As shown in the figure below, in the past 50 years, when the earnings of listed companies reached the bottom, the P/E ratio of the S&P 500 index was exactly 20 times.

So, what factors are related to the P/E ratio of the S&P 500 index?

Subramanian's answer is that since the global financial crisis, the valuation of the S&P 500 index has been far more related to quantitative easing than to earnings, trading volume, or other factors.

In fact, Bank of America's analysis shows that since 2010, the quantitative easing of the Federal Reserve has explained more than half of the profit growth in the United States, and the P/E ratio of super large growth stocks is even more closely related to quantitative easing. Now, with the Fed's quantitative tightening, Subramanian expects that the stock prices of these companies will face greater pressure.

There are also some things that may be more noteworthy: according to Subramanian's statistics, excluding the 50 largest stocks, the P/E ratio of the S&P 500 index is only 15 times, which is lower than the historical average of 18 times.

The risk premium of most cyclical stocks is higher than the average level reflecting recession risk, while the risk premium of defensive and long-term growth stocks is lower.

Subramanian concluded:

Valuation that standardizes (rather than tracks) returns has strong explanatory power, but only for long-term returns. Historical P/E ratios have low predictive power for short-term returns.