If you love volatility, then you were loving last week’s price action.

Fed weeks are rarely boring and this one included a mini-vol crush and rally on Wednesday followed by a historic all-out real money liquidation of financial assets on Thursday.

Tech swung from the biggest rally in years to the biggest selloff in years.

The Nasdaq-100 made a new low and is now -25% since the all-time high put in last November. 

Here is the Invesco QQQ Trust ETF (QQQ) 15 minute candlestick chart from last week …

This ride over the past year has been wilder than any you’ll ever find at Busch Gardens here in Tampa, that’s for sure. 

We have gone from an all-out everything bubble – bonds, stocks, crypto, real estate, art, wine  etc. to finding out what stuff is really worth without out-of-control central banks printing money  into oblivion.  

Today we’ll take a look at where this meltdown is likely to stop. 

S&P 500 Index (SPX) Fair Value

The most commonly used stock market valuation analysis is the price-to-earnings – that’s the stock’s price divided by the firm’s yearly earnings per share. 

P/E is also a measure of how many years it will take for an investor to earn back principal from an initial investment.

Let’s look at P/E ratios for a stock with steady earnings compared to a stock that is expected to grow, also known as a value vs growth comparison.

Value Stock: If you buy one share of XYZ company for $100, and XYZ consistently makes a profit of $10 per-share, per-year, then it follows that it would take you 10 years to earn back your original $100 investment.

Growth Stock: Now let’s say you buy a share of stock in ABC company with the same $100 price as XYZ. Their earnings per year, per share for the last five years have been $0, $1, $1.50, $2 and $5. 

ABC’s P/E ratio is then $100/$5 = 20. And lower P/Es are generally better for investors.

The message here is that, at current earnings, investors in ABC will theoretically get their money back after 20 years. That’s twice as long for ABC and XYZ because it takes ABC twice as long to make the same level of profits.

This simple example reveals the clear distinction between value stocks and growth stocks. 

The reason why high-growth companies tend to have very high P/Es is because the market has very high expectations for their future results.

Inflation and the end of central bank money printing is forcing a revaluation of all stocks but, in particular, growth stocks … 

To go from $6 trillion injected mostly into the financial system to money being drained through government tightening will force the cyclically adjusted price earnings (CAPE) ratio back down to its historical average.

S&P 500 CAPE Ratio vs Historic Average

The chart below shows the current S&P 500 price divided by the average earnings over the prior 10 years. This smooths out volatility periods and gives you a stable historical average to compare against.

A couple of observations from the chart above …

As you can see, the historical average is 19.6% versus today’s CAPE ratio of 32%. So, if we simply take 12% off today’s price the SPX would drop to 3,600 … 

And 3,600 has been tossed around as the level that would trigger a Fed shift away from the aggressive tightening path they are currently on.

The current path priced into the market is eight hikes of .25% in 2022 plus quantitative tightening (QT) that starts June first with a cap of $47.5 billion a month for 3 months, then rising to $95 billion per month. 

The S&P 500 Historical Average P/E Price

Now, the way to get to the 3,600 level is by assuming the earning forecast currently being used doesn’t change. 

But that is not a valid assumption since SPX will drop further as future earnings projections are lowered and financial asset prices continue to drop.  

So, a more realistic way to come up with a fair estimate on how low prices can drop based on the CAPE ratio analysis is to show a fair value of the SPX P/E based on the historical average of 20 …

Since the less wealthy are getting hit the hardest by inflation, governments are going to try to one up each other on who can be more hawkish on inflation.

The theory is that what needs to happen now is a controlled reallocation of wealth from the 1% to the 99%, to a level that both sides can be comfortable with. 

Look at Biden’s billionaire tax where their thinking is go after people with a $100 million … who’s going to know a zero here or zero there … they will be OK.

So, whether it is a tax by forcing financial assets lower or a straight tax that will still force equity liquidation, stocks will go lower until something in the system breaks – and there are no signs of that just yet.

Bring It Home

This week we will get the consumer price index (CPI) on Wednesday, producer price index (PPI) on Thursday and consumer sentiment of Friday …

This is the tug-of-war we are watching closely.

Inflation versus consumer spending will show us the amount of demand destruction that inflation is causing for the consumer. 

I foresee numbers will continue to be strong for the next couple of months, but my call has been that we will see the rate of change – meaning year over year changes in inflation – peak in Q2.

Technically the 400-405 level in the S&P 500 index ETF (Ticker: SPY) continues to be major support, so unless we get shocking news that forces real money liquidations of equities that area may hold into Friday’s expiration.

We will take a closer look at our weekly watchlist on Macro Monday at 11 a.m. today. That event is open exclusively to Power Income Trader members.

Live and Trade With passion My Friend,

Griff