2025-04-08T05:29:49.000Z

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Welcome to our latest edition of the Unhedged newsletter, where we bring insights and analyses on current market trends. For those interested in receiving our newsletter every weekday, premium subscribers can sign up here for exclusive content. Standard subscribers also have the option to upgrade to Premium or explore a variety of other newsletters we offer.

Good morning to our readers! Yesterday saw a brief yet intense revival in the financial markets, triggered by circulating headlines suggesting that President Donald Trump was contemplating a 90-day suspension on the tariffs recently introduced. However, the White House swiftly dismissed these rumors, clarifying that no such pause is in effect. Consequently, the market experienced another downturn, leaving many investors grappling with uncertainty. The desire among many to cling to the hope that these tariffs might never come to fruition is palpable. For thoughts or suggestions, feel free to reach out via email at robert.armstrong@ft.com or aiden.reiter@ft.com.

The question now arises: Is risk being undervalued in today’s market?

The S&P 500 index has witnessed a notable decline of 18 percent from its peak earlier this year in February. At first glance, this might not seem overly alarming, especially when we juxtapose this decline with previous bear markets. For instance, the bear market experienced in the fourth quarter of 2018 saw a more significant drop of 20 percent. Many may not even recall that period, as it didn’t even earn a nickname. Meanwhile, the market downturns of 2022 (prompted by inflation concerns), 2020 (as a result of the COVID-19 pandemic), and the 2008 financial crisis recorded declines of 25 percent, 33 percent, and a staggering 57 percent, respectively.

Despite this relative mildness, the speed at which the current decline has occurred is concerning. The volatility observed across various markets suggests that the crisis stemming from the tariff situation may not be resolved just yet. For investors who are rational and perhaps fortunate enough to have cash reserves or short-term bonds—Warren Buffett being the most notable example—this volatility raises intriguing considerations. Rather than succumbing to panic and selling off assets, there is a compelling argument to be made for viewing this as an opportunity to buy. Although we are undoubtedly in a challenging economic landscape, history shows that markets often overreact to turmoil.

In light of these developments, it is crucial to reflect on whether risk markets are currently priced to yield strong long-term returns. Various methodologies can be employed to gauge this, though none are entirely satisfactory on their own; nevertheless, each provides valuable insight.

Let’s begin with the most fundamental valuation metric: the price-to-earnings (PE) ratio. The forward PE ratio on the S&P 500 has returned to pre-pandemic levels, which remains relatively high when evaluated against the average of the past two decades. To fully comprehend this ratio, one might consider why valuations have remained elevated in the post-pandemic era (excluding the inflation spike of 2022). A favored theory among analysts is that loose fiscal policies during a significant portion of this time have propelled liquidity into the markets. If one subscribes to the belief that fiscal tightening is on the horizon—an expectation held by some members of the Trump administration—then stocks may not actually be perceived as ‘cheap’ when evaluated through the PE lens. In fact, they might be poised for below-average long-term returns.

When contemplating the PE valuation, it is vital to focus on the “E”—that is, the earnings potential of corporations. Specifically, has the potential impact on corporate earnings from increased tariffs been factored into the earnings outlook? Current assessments indicate that this potential damage may not have been fully accounted for, particularly from a “bottom-up” perspective, which aggregates individual earnings estimates for companies within the S&P and weights them accordingly. According to insightful data from FactSet’s Earnings Insight, the S&P 500 earnings estimates for 2025 have only decreased by 7 percent since September, exhibiting minimal change since what some may refer to as “liberation day.” This indicates that if tariffs are expected to be substantial and long-lasting, earnings estimates could still have room to drop further, implying that the current PE ratio may indeed be artificially low.

A more nuanced version of the PE ratio is the cyclically adjusted earnings yield, commonly referred to as the “Cape” yield, which is calculated by Yale economist Robert Shiller. This method inverts the PE ratio (expressing it as E/P), utilizes a 10-year average for earnings as “E,” and subtracts the 10-year Treasury yield to account for interest rate fluctuations. This adjustment allows for a smoothed measure of the additional yield investors receive from stocks relative to Treasury bonds. Recent analysis indicates that the excess yield from holding the S&P 500 has increased by nearly a full percentage point; however, it still doesn’t appear particularly enticing.

Another way to assess valuations involves examining the equity discount rate—the rate of return that aligns current stock prices with anticipated future cash flows. Michel Lerner and the HOLT team at UBS have posited that elevated tariff levels should elevate the discount rate (thereby reducing stock prices). Lerner elaborates, explaining that trade liberalization since the establishment of the World Trade Organization in 1995 has been pivotal in driving inflation down, as noted by the European Central Bank. This influx of competition and reduction in production costs has contributed to a significant decline in interest rates, consequently reflating equity markets. Historically, the US discount rate fluctuated between 5 and 8 percent for the better part of 150 years, but post-1995, excluding the Global Financial Crisis, it never surpassed 5 percent. Notably, during a more mercantile era before 1945, the US discount rate would spike with the introduction of large tariffs on imports.

Recent data reveal that the discount rate has climbed from 3.1 percent to 3.6 percent since early April. However, Lerner notes that we are still not at levels that would indicate a new normal or a recession. It’s crucial to recognize that a 1-percentage-point shift in the discount rate can lead to a 20 percent movement in stock prices, meaning that a return to pre-1995 averages could result in significant declines.

If these financial concepts seem somewhat abstract, one can easily look at the prominent technology stocks that have driven movements in the S&P 500. A recent analysis of five major tech stocks, excluding the more volatile Nvidia and Tesla, reveals that despite enduring the brunt of the tariff-induced sell-off, these stocks have lost only about a year's worth of gains. Essentially, the significant rallies observed recently have merely reversed direction, rather than indicating a massive downturn.

The overall picture is clear: stocks are not bargains at this moment. However, if the implications of Trump’s tariffs linger, it may be prudent to contemplate the level at which stocks could become genuinely appealing investments. Jeremy Grantham’s compelling GMO letter, titled “Reinvesting When Terrified,” serves as an essential read for investors, providing insights at the 2009 market low. He emphasizes the importance of having a battle plan for reinvestment and adhering to it, cautioning against the paralysis that can stem from trying to time the market optimally. Grantham states, “There is only one cure for terminal paralysis: you absolutely must have a battle plan for reinvestment and stick to it.”

In summary, as we navigate this complex economic environment, it is crucial to remain informed and prepared. More insights and analyses on these pressing matters will follow in the upcoming days.

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