Have stocks stopped being expensive? Among bulls, hope is coalescing around valuation metrics that could support that view, though with so many caveats they require a big dose of courage to heed. 

After falling 15 per cent this year, the S&P 500 is trading around 4,000. According to analysts tracked by Bloomberg, its members will earn a combined US$248 a share next year. Divide price by earnings, and the result is a forward multiple of 16 -- roughly in line with the three-decade average. So not dirt cheap, but perhaps reasonably priced.

Dip buyers have been wading back into the market. Stocks have risen in four of five sessions, lifting the index almost seven per cent from its intraday low Friday. A weakening dollar, less-hawkish Fed commentary and decent retailer earnings did some of the lifting. Behind them is a prayer that the US$8 trillion drawdown since January has left prices less vulnerable to economic shocks.

“One of my broad thoughts on the market is that it represents an incredible value,” said Josh Wein, portfolio manager at Hennessy Funds. “And when you drill down individual companies, needless to say, it’s the same thing.”

Arguments that the selling has gone too far have been put forward by analysts at Goldman Sachs Group Inc. and JPMorgan Chase & Co., who say recent price action overestimates the likelihood of a recession. A quick bounce could take hold should bond yields peak, Credit Suisse Group AG similarly contended. Behind each prediction is a belief that valuations already account for all the pain that is likely to be visited on the economy and earnings.

What could go wrong? A lot. The calculation in the above exercise is based on forecast earnings, the reliability of which is suspect, especially when the Fed is raising rates. Analysts have a long history of missing downturns. Case in point is the start of 2008, eve of the global financial crisis. Estimates at the time called for a 15 per cent gain in S&P 500 profits.

Treating historical P/Es as reliable signposts for a floor is risky too. With inflation raging and the Fed committed to an aggressive tightening campaign, the backdrop is one of the most ominous for equity valuations in decades. In bear markets, stocks rarely stop falling at the average P/E. Rallies like this week’s are common features of much bigger plunges.

“It’s dangerous to anchor too much on the E,” said Giorgio Caputo, senior fund manager at J O Hambro Capital Management. “We’re dealing with a wide range of economic outcomes, and if we do go into some sort of a recession, it’s very likely that that E will have to come down significantly.”

History holds numerous examples of stocks that looked like bargains relative to forecasts but ending up as anything but. Since World War II, corporate income has tended to drop a median 13 per cent around economic retrenchments, according to data compiled by Goldman Sachs strategists led by David Kostin. 

Of course, timing the top of a growth cycle is next to impossible. But for the sake of illustrating the point, assume Corporate America is able to deliver on what it is expected to earn this year: US$227 a share. Then assume a recession hits and profits shrink by the 13 per cent in 2023 that is typical of an economic contraction.

In that scenario, S&P 500 profits would be US$198 a share, rather than the US$248 now projected by analysts. And instead of sitting at a reasonable-looking multiple of 16, stocks would be priced at a P/E ratio of 21. 

“We don’t think those multiples are going to hold and we think the earnings have to come down,” Alicia Levine, head of equities and capital markets advisory for BNY Mellon Wealth Management, said in an interview on Bloomberg TV. “You can just see where the commentary is going on supply chain and the impact of inflation.”

With interest rates on the rise, it also begs the question of what’s the proper valuation for equities. One approach to help answer that is something known as the Fed model that compares 10-year Treasury yields and the earnings yield of the S&P 500, a reciprocal of P/E. 

As things stand now, the picture shows stocks as still moderately expensive relative to the history of the post-crisis bull market, but quite cheap compared with the longer historical series -- a period in which bond yields were generally much higher. 

While first-quarter earnings continued to beat estimates, there are signs that analyst expectations for the next two years -- for growth of about nine per cent each --  might be too optimistic. 

One big threat comes from the Fed, whose campaign to fight the highest inflation in four decades involves bringing down both share prices and corporate earnings to ease wage pressure and consumer demand, according to Nicholas Colas, co-founder of DataTrek Research. He doesn’t see a bottom until the S&P 500 hits 3,500, or a 27 per cent drop from its January peak. 

“For Fed policy to take a bite out of inflation, it also likely must take a bite out of corporate profits,” Colas wrote in a note. “Markets can’t pay for what they can’t see, and right now the runway for corporate profits is fogged over.”