2024 correction and market balance from the last 25 years

Today, we will compare where US stocks are now corrected to what the relatively long-term market balance has been for the past 25 years. Our benchmark in each case will be valuations corrected for the effect of changes in government bond yields.


1. Technical to PE, EP and bond yield: The following chart shows the evolution of the spread between inverse PE and ten-year government bond yields. Reverse PE, or EP, is often called earnings yield and is the ratio of earnings per share to share prices. The size of that difference then, simply, shows how much valuations (ie PE) at a given time are driven by risk premiums and expected long-term earnings growth.

In particular, the higher the PE (relative to risk-free rates) due to the growth outlook or low risk premiums, the lower the EP relative to these rates (and the -their difference goes down). And vice versa. At the same time, the graph shows that the last 24 years have produced a whole range of values. After 2000, EP remained below zero relative to bond yields for some time. At the end of 2002, the difference between the two variables reached a certain level, and the median is around 1.5. After 2008, a rate of 3.5 appeared for a while, and then the difference narrowed – valuations increased relative to income, so EP decreased relative to income:

Source: X

2. Still optimistic after the correction, compared to past balances: This year, the values ​​in the graph went below zero, the current price and valuation correction raised them to slightly positive numbers. However, this graph also shows what I wrote here a few days ago. The current events on the markets can be portrayed as a dramatic event, but overall it is only a small correction of very high optimism regarding future risk and growth.

For example, if the shares theoretically reached that level of around 1.5 (from the period 2002-2007), this would mean that the EP would now have to reach 6.4% and the PE therefore 15.6 . Instead of the flow around 20. This does not mean that prices had to fall by 22%, it would be enough to wait with stagnant prices for a cumulative profit growth of 22%. If, in this hypothetical scenario, the consensus profit expectations come true (see the following chart), the market would reach this new equilibrium sometime in 2026:

Source: X

The other two balances (difference 3 – 3.5) would actually mean an even lower valuation – EP was higher relative to bond yields so their difference was also higher. At the same time, my aim here is not to fear further market decline or price stagnation in the long term. Instead, we can see from examples like this how amazing the current expectations are regarding the benefits of new technologies.

3. A little technicality at the end: The difference between the yield of non-core and ten-year PE bonds is surprisingly often given as the stock’s risk premium. Ie it is not taken into account that the expected growth has a role in profits and dividends. Mathematically, it can be easily deduced that this is an oversimplification, and we can see from the graph that these “premiums” would be in the negative after 2000 and this year. Technically, this means that investors would pay more for higher risk and get paid for some less risky assets.