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Stock market: the bear market is not over…

  • Post category:Economy News
  • Reading time:18 mins read

Eric Galiegue

The deterioration in the news has very significantly increased the probability of the stagflation scenario occurring. It is now almost certain that we are in stagflation. What are the effects of this context of weak growth and the return of rising prices on the valuation of the major indices?

We carried out an empirical evaluation exercise of the S&P 500, the Eurostoxx, and the CAC 40. To establish the theoretical value of the indices, we made 3 assumptions:
 An assumption on interest rates (USA and € zone)
 A PER hypothesis according to the interest rate (behavioral approach)
 A normative profit margin assumption to determine EPS
The PER applied to a normative BPA makes it possible to calculate the valuation of the indices

Interest Rate Assumption

The Congressional Budget Office (CBO) is a federal agency attached to the American parliament, whose mission is to carry out “non-partisan” studies on subjects related to the American federal budget. It regularly updates budget projections for the next 30 years, with 10-year interest rate assumptions that can be considered sensible.

source: CBO

source: CBO

We retain the rate of 4%, the CBO’s assumption for its projections for the next thirty years; this rate also corresponds to the average of the last thirty years.

For France, we have chosen the rate of 2.7%, which also corresponds to a long-term average, from the introduction of the cashless € (early 1999), until now…

Source: Facttet and Valquant Expertyse

Source: Facttet and Valquant Expertyse

PER assumption

There is a strong theoretical relationship between the interest rate and the level of PER. The observations of the last 20 years make it possible to establish the empirical statistical relationship, which will make it possible to define a PER according to the interest rate.

Source: Facttet and Valquant Expertyse

Source: Facttet and Valquant Expertyse

Thus, the formula: “PER = 18.33 – 0.933 * Interest rate” makes it possible to determine a PER of 14.6X for the S&P 500. This PER is almost 2 points lower than the currently observed PER of 16.7X …

Profit hypothesis

To determine the EPS needed to calculate the valuation of the CAC 40, we base ourselves on the median net margin of the companies that make up the S&P 500. It has evolved as follows over the past 20 years:

Source: Facttet and Valquant Expertyse

Source: Facttet and Valquant Expertyse

The line that appears on the graph is simply the long-term trend, determined by regressing the margins over time. It allows us to better visualize the permanent improvement in the net margin of American companies, which has doubled in 20 years. It also makes it possible to determine a normative margin, which appears in red on the graph. It appears that in the USA, the 2023 margin of companies anticipated by analysts (14.9%) is 1.4 points higher than the normative margin, calculated from the long-term trend (13.5%). The EPS adjustment factor is 13.5/14.9, i.e. approximately 10%: we consider that current EPS is 10% higher than its normative level. It is this normative level that we use to establish the theoretical valuation of the S&P 500.

Final assessment

The multiplication of the PER associated with the interest rate assumption (4% in the USA, 2.7% in France), by the normative EPS, determines the valuation of the stock market index. We conducted these calculations on the S&P 500, Eurostox and CAC 40 indices.
The results of this behavioral evaluation of the indices appear in the following table:

source: Valquant

source: Valquant

It thus appears that even after the price correction, stock market indices are overvalued by 5 to 20%. More specifically, the evaluation of the CAC 40 is around 5700 points, ie 8% less than the current price. The bear market is not over.