The S&P 500's valuation has dropped by a third

Key points:

• The S&P 500's trailing Price/Earnings Ratio has declined 35% from its 3-year high
• That ranks among the largest drawdowns in valuation in 70 years
• Forward returns from similarly sharp valuation contractions tended to be good over the next several months

Valuation has dropped by a third

Stock prices have taken a tumble, but as-reported earnings haven't. Prices usually lead earnings, so it's possible (probable, even) that earnings will start to decline.

But they haven't yet, so the combination of falling prices and steady or even rising earnings has caused the S&P 500's Price/Earnings Ratio to plunge. As it craters below 20, the P/E Ratio is nearing its average of 17 from the past 70 years.

While the S&P has pulled back less than 15% from its one-year high, its valuation metric has plunged more than twice as much, more than 35%. The largest drawdown in valuation from a three-year high was 63% in 1974 followed by a couple of 50% resets after the 1987 market crash and the 2008 financial crisis. The current drawdown ranks in the bottom 15% of all days since the early 1950s.

The S&P 500's annualized return when its P/E Ratio was more than 35% off its peak was an impressive +19.6%, thanks to large and persistent rebounds following protracted selloffs.

The table below uses a signal-based approach, looking at the S&P's future returns once its valuation dropped by more than 35% from a multi-year high. Over the medium-term, its performance was very good, with only isolated and small losses. But two of them, in 1974 and 2001, triggered during the halfway mark of protracted bear markets.

So, is the S&P 500 index's price more likely to catch down to its valuation, or is its valuation more likely to catch up to its price? Divergences are always tricky, but the table below shows every time the index was in less than a 15% drawdown while its valuation drawdown was at least twice that.

Returns were good for the index going forward, about in line with random up to six months later. From there forward, though, the S&P did very well, at least in terms of consistency. Its average return was mediocre, but it showed a positive return every time over the next year.

What the research tells us...

Investors are dealing with a head-spinning number of cross-currents at the moment, and the market environment doesn't help. It's very poor, rallies are being sold, and extremes aren't generating the kinds of buying interest that characterized much of the past 12 years. The past week witnessed more extremes in pessimism, which even during bear markets tend to lead to multi-week or even multi-month rebounds. The sudden re-valuation of the most important index in the world is becoming compelling because that was a major headwind heading into this decline. Now, we need to see some of the bear market hallmarks evaporate and get some thrusts in buying interest that don't get sold immediately.