Equity returns were largely positive in the first five months of 2023. The question now is whether earnings forecasts, which stabilized in the first part of the year (Figure 6), will turn down again. 

Page says he suspects they will. As of late May, he notes, 2024 earnings growth projections for the stocks in the S&P 500 Index were still in double digits. “We know that Wall Street analysts tend to wear rose‑colored glasses, but I think those expectations will have to come down.” 

Assuming the global economy enters a mild recession, 2024 global earnings could be flat to down 5%, Thomson estimates.3 Compared with past earnings cycles, that could be viewed as a bullish outcome. “At this stage, I think we’re looking at a fairly benign cycle.” 

Even a modest earnings decline would put further pressure on stretched US large‑cap valuations. Back when the Fed was holding rates close to zero, Page recalls, a favorite Wall Street acronym was TINA—There Is No Alternative. “Well, TINA has left the building,” he says. “There are alternatives now.” 

By some measures, US large‑cap stocks actually appear more expensive than they did before last year’s bear market, Page says, even though the price/earnings ratio (P/E) on the S&P 500 Index has fallen. 

The valuation model used to calculate the equity risk premium—the added reward for taking on the additional risk of holding stocks rather than bonds—compares the earning yield on the S&P 500 (the inverse of the P/E) with the 10‑year Treasury yield. At the beginning of 2022, Page notes, a P/E of 23 on the S&P 500 translated into an earnings yield of 4.3%, versus a 1.5% yield on the 10‑year Treasury note. That put the equity risk premium at 2.8 percentage points. 

By late May of this year, the P/E on the S&P 500 had fallen to 18.4, raising the earnings yield to 5.4%. But the 10‑year Treasury yield had risen even more, to 3.7%. Net result: an equity risk premium of 1.7 percentage points—lower than before the 2022 equity sell‑off. By that same measure, Page adds, US equity valuations currently are in the least attractive 5th percentile of their 10‑year historical range.⁴

US Small Caps Are Cheap

There are, however, bargains to be found in the US market, Page adds. Many quality small‑ and mid‑cap stocks are trading at significant discounts to their historical averages. While the S&P 500’s P/E is closer to the top of its 10‑year range than to its bottom, Page notes, the reverse is true for the S&P 600 Index—a leading US small‑cap benchmark. “US small‑caps are priced like it’s 2008,” he says.

Of course, small‑cap valuations are low in part because many investors are worried about the risk of recession, and smaller companies historically have been more vulnerable in economic downturns. But, as with high yield bonds, skilled security selection can help active portfolio managers avoid companies with weak balance sheets and high cyclical earnings exposure, Page contends.