The S&P 500's Prospects Are Poor

The S&P 500 has suffered a drawdown of more than 10% since the turn of the year. Many investors believe that the dip presents an opportunity to capitalize on a transitory drawdown. However, it needs to be considered that price alone isn’t an indicator of future returns. The S&P 500 isn’t in good shape right now; here’s why.

The Fed and Yardeni valuation models

The Federal Reserve’s model values the S&P 500 by looking at the index’s earnings yield and the 10-year yield differential. It’s fair to say that they’ve been growing linearly lately, and that’s a likely explanation for why we’ve seen a market that’s struggled to find direction in the past few weeks.

The S&P 500’s Prospects Are Poor

Source: Yardeni Research

The Yardeni model takes a slightly different approach. The model incorporates forward earnings into the valuation, and it’s conveyed that the S&P 500 is trading at an 18.8 forward price-earnings ratio and a 1.2 PEG ratio. One would think that the price-earnings ratio is respectable, but a PEG ratio of above 1.00 indicates that the earnings growth of the index is stale, thus leading me to conclude that the market is slightly overvalued.

The S&P 500’s Prospects Are Poor

Source: Yardeni Research

Index breakdown and economic outlook

The above valuation charts can’t be looked at in isolation. We need to look at the breakdown of the S&P 500 and the economic outlook to contextualize matters further.

I’m concerned about the fact that the information technology sector comprises approximately 28% of weight of the S&P 500. The reason for my concern is that we’re in a value and quality cycle, which works against growth stocks. Additionally, by the time the index gets rebalanced, we’re likely to have exited the value and quality-seeking environment.

The S&P 500’s Prospects Are Poor

Source: The Balance

From a pure economic perspective, the S&P 500 is faced with a series of headwinds. We’re likely heading for stagflation, which could counteract earnings growth and cause investors to pull money out of the stock market to meet household obligations.

Furthermore, it must be remembered that the stock market’s growth is essentially down to economic cycles, plus price valuation multiples, plus a residual value or error term. These factors are interlinked, which causes momentum; a downward momentum pattern in some of the mega-cap stocks could be a big shock to the broader market.

The bottom line

The bottom line is that the S&P 500 remains in bad shape. A few stocks are well aligned for growth, but the index is top-heavy with tech stocks, which is the likely reason why the Yardeni model indicates that the S&P 500 is overvalued.

This article first appeared on GuruFocus.