Stock valuations are still high, and that suggests the market has yet to bottom and could fall as much 30%, Bank of America says
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- The stock market has yet to find its bottom based on its rich valuation, according to Bank of America.
- BofA said elevated valuations suggest the stock market could ultimately fall 30% from current levels.
- "The S&P 500 still screens as statistically expensive vs. history on 17 out of 20 measures we track," BofA said.
Despite the stock market's 19% decline in 2022 amid positive earnings growth, there could still be more pain ahead, Bank of America said in a Monday note.
The bank said valuations are still too high for the stock market, which means a bottom has yet to be reached for stock prices.
"The S&P 500 still screens as statistically expensive vs. history on 17 out of 20 of the measures we track," Bank of America's Savita Subramanian said. "Ahead of prior market bottoms, the index screened as expensive on just four measures, on average."
Prior stock market bottoms saw the S&P 500 trade below its average forward price-to-earnings ratio, its trailing normalized price-to-earnings ratio, and its median forward price-to-earnings ratio. "But it trades above average on all three today," Subramanian highlighted.
The valuation differences are even more extreme when you compare stocks to bonds, according to the note, which suggests big moves in markets for a return to the average.
"Where stocks traded cheap relative to bonds over the last 10+ years, the income differential now indicates 30% downside risk to stocks or 30% upside risk to bonds to get back to historical averages," Subramanian said. Such a decline would send the S&P 500 to levels not seen since the onset of the COVID-19 pandemic in April 2020.
Giving Subramanian additional pause in believing that the worst is over for the stock market is the fact that only 40% of BofA's "bull market signposts" have been triggered in recent weeks. That's compared to the typical 80% of bullish signposts that would be triggered before prior market bottoms, according to the note.
Despite the bearish outlook, Subramanian did highlight one factor that could serve as a tailwind for stock prices going forward: everyone is bearish. According to BofA, Wall Street strategists have aggressively increased their exposure to bonds relative to stocks during the turmoil and volatility of 2022.
Even hedge funds are now 40% net long utility stocks, which is the most bond-like sector in the S&P 500 and speaks to widespread risk-off sentiment among market participants.
"Given drops in equity sentiment and positioning, one of the biggest risks today might be that of being under-invested in stocks," Subramanian said.
Of all the sectors in the market, Subramanian is most bullish on financial stocks and believes they "may be a good spot to park assets in the near-term" as the broader market takes time to find its footing.
"We are overweight the sector and see it as a higher quality sector with better earnings stability than the S&P 500, cleaner balance sheets thanks to US regulators, and less recession risk than other more crowded and expensive cyclical sectors like Info Tech," Subramanian said.
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