U.S. equities bears have been out in full force during the first nine months of 2023. The most common bearish thesis over the summer sounded something like this: The Federal Funds rate is now 5.50%. With stubborn inflation, the Federal Reserve is unlikely to lower rates until the end of 2024. This delay will eventually cause a recession. The S&P 500 trades close to 19 times 2024 earnings versus the long-term average of 15.7 times, so equities should fall below the long-term average P/E. This means the S&P 500 will fall at least 20%.

Indeed, at the start of August, the S&P 500 traded close to 19 times earnings, versus the long-term average of 15.7 times. The S&P 500 valuation appeared to be about 20% above average.

This bearish argument is simple and logical. However, what could derail this nearly consensus view? The answer may be synthesized into a single word – “What.”

What caused the S&P 500 to trade to 19 times earnings? What does the present inflation trend mean for the Federal Funds rate?

First, valuation. After trading north of 19 times earnings at the summer peak, the S&P 500, after a two month correction, finished the third quarter at a P/E of 17.7. However, within the index, a large number of companies experienced full bear market corrections. By the time the third quarter ended, the cohorts of strong performance and high valuation were dominated by a small number of companies…typically the largest companies in the index.

As we analyzed this phenomenon, we found a number of intriguing facts. First, if you simply excluded the five largest companies in the S&P 500 (Apple, Microsoft, Google, Amazon, and Nvidia), the P/E for the remaining 495 companies fell to 16.1 times. Next, if you excluded the ten largest companies, the P/E for the remaining 490 companies fell further to 15.6 times. Finally, if you also excluded the five largest consumer staples companies, the companies investors bid up fearing a recession, the remaining 485 companies traded at 15.3 times earnings – about 3% below the long-term average.

The table below depicts our work.

Essentially this indicates the overvaluation in the S&P 500 is mainly derived from 15 companies or 3% of the total number of companies in the index. Those 15 companies comprise over 35% of the market capitalization of the entire index, so their high valuations really affect the overall index. Knowing this, one could surmise that the “S&P 485” is not only inexpensive but is a large breeding ground for portfolio ideas.

Second, what does the present inflation trend mean for the Federal Funds rate? The bearish narrative that inflation is too high and interest rates will be unchanged over the long-term appears to be losing credibility by the week.

Last fall when Core CPI was 6.64% year-over-year and the Federal Funds rate was 3.25%, there was certainly an easy argument to be made that inflation was extremely high and the Fed Funds rate needed to be higher – inflation was 3.4% above Fed Funds.

However, fast forward to a year later, and the situation is wildly different. Core CPI was just released at 4.13%. This figure is above the 30-year average of 2.4%. However, inflation is consistently falling, while the Fed Funds level is now 5.50%. In one year, the difference between core inflation and the Fed Funds rate has fallen from +3.4% to -1.2% as inflation is now well below Fed Funds (and falling).

If inflation is headed down toward the 1995, 2001, and 2006 highs at around 3%, where does this chart indicate the appropriate Fed Funds level is found? Probably not 5.50%.

Although U.S. equities are affected by many other factors from earnings cycles to currency to political and geopolitical risks, the concept that domestic equities need to fall 20% because of the overvaluation of the S&P 500 and high inflation causing high interest rates does not appear to be a high probability outcome, especially after last year’s U.S. equities rout.