When to buy the dip

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Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.

Good morning. The market had a brief, furious revival yesterday, when headlines circulated saying that President Donald Trump was considering a 90-day pause on the newly announced tariffs. The White House declared no such pause was in play, and the market fell again. People really want to believe that these tariffs are not going to happen. We don’t know what to believe, so send suggestions: [email protected] and [email protected]. 

Is risk cheap now?

The S&P 500 has fallen 18 per cent from its February peak. That ain’t that bad. 

Remember the bear market in the fourth quarter of 2018? No? Many won’t. It doesn’t even have a name. But the market was down 20 per cent. Meanwhile, the decline of 2022 (inflation panic), 2020 (Covid-19) and 2008 (great financial crisis) weighed in at 25 per cent, 33 per cent and 57 per cent, respectively. 

But the speed of the decline is worrisome, and the volatility across markets suggests the tariff crisis may not be over yet. For investors who are rational and lucky enough to be sitting on cash or short-term bonds — Warren Buffett being the most prominent example — the prospect of further declines will have them thinking of buying, not selling. We are in a real mess, but markets overreact to messes every time. 

So now is a good time to think about whether risk markets are priced to provide strong long-term returns. There are lots of ways to look at this, none of them completely satisfactory, but all of them have something to say.

Start with the most basic valuation metric of all, the price/earnings ratio. Here is the forward PE on the S&P 500, with the current level shown by the red line.

We have reverted to the pre-pandemic level of the PE ratio, which is still relatively high when compared with the past two decades. To read this chart, you might want to have some sort of theory about why valuations have been high post-pandemic (apart from the 2022, when inflation jumped). Unhedged’s favourite theory is that fiscal policy was extraordinarily loose during most of the period, pushing money into markets. If you believe that fiscal tightening is coming (as some in the Trump administration have promised) then stocks don’t look cheap here on a PE basis. They might even be priced to give below-average long-term returns. 

It is important, when thinking about PE valuation, to think about the “E”. Specifically, has the potential damage to corporate earnings from higher tariffs been priced into the earnings outlook? It appears they have not, at least on a “bottom up” basis — that is, taking the individual earnings estimates for each company in the S&P, weighting them, and adding them up. Below, from FactSet’s excellent Earnings Insight, is an S&P 500 earnings estimate for 2025. It has come down only 7 per cent since September, and hardly at all since “liberation day”. So, if you think the tariffs will be high-ish and permanent-ish, estimates probably have room to come down from here, meaning the PE ratio is artificially low right now. The 2026 estimate has come down even less. Again: not cheap.

A slightly more sophisticated version of the PE ratio is the cyclically adjusted earnings yield (“Cape” yield), as calculated by Yale’s Robert Shiller. This inverts the PE ratio (making it E/P), uses 10-year average earnings as the “E”, and subtracts the 10-year Treasury yield from the result, to adjust for the impact of interest rates. It’s a smoothed measure of how much extra yield you get from stocks, relative to Treasuries. So on the below chart, higher means cheaper. As you see, the excess yield from owning the S&P 500 has risen by almost a full percentage point recently, but still doesn’t look particularly juicy yet. 

A related way to think about valuation is with equities’ discount rate: the rate of return that matches equities’ current prices to their expected future cash flows. Michel Lerner and the HOLT team at UBS argue that high tariffs ought to bring the discount rate up (and stock prices down). He writes:

Trade liberalization following the creation of the World Trade Organization in 1995, arguably, has been instrumental in driving inflation down (per the European Central Bank, more competition, lower production costs…), in turn allowing interest rates to fall more than ever and reflating equity markets in the process. 

To that effect, for the better part of 150 years, the US discount rate ranged between 5 and 8 per cent. From 1995 onwards, excluding the Global Financial Crisis, it never exceeded 5 per cent. It is notable as well, that in a more mercantile pre-1945 era, the US discount rate spiked every time the US slapped large tariffs on imports . . . (1890 McKinley Tariffs, 1922 Fordney-McCumber Tariffs, 1930 Smoot-Hawley Tariffs).

Below is a chart of the discount rate until April 1. The discount rate has risen from 3.1 per cent to 3.6 per cent since then, but Lerner says that even so “we are not at levels consistent with a new normal or a recession”. 

Every 1-percentage-point change in the discount rate translates to about a 20 per cent move in stocks, so a return even part of the way towards the pre-1995 average would hurt a lot. Once again: stocks are not priced for high long-term returns yet. 

If all this strikes you as a bit abstract, just look at the prices of the huge tech stocks that have driven, and still drive, the moves in the S&P 500. Here is a chart of five of them (excluding Nvidia and Tesla, whose wild prices make the chart harder to read). What you see is that the prices of these stocks — despite getting the worst of the tariff sell-off — have only given up a year or so of gains. All that has happened is that an extreme recent rally has been reversed:

It’s quite clear. Stocks are no bargain. But Trump’s tariffs may not be done with us yet, and if they are not, now is the time to think about what the bargain level might be. The best thing written on this point is Jeremy Grantham’s absolute banger of a GMO investor letter, “Reinvesting When Terrified”, which he penned right at the 2009 market low. Grantham wrote: 

As this crisis climaxes, formerly reasonable people will start to predict the end of the world, armed with plenty of terrifying and accurate data that will serve to reinforce the wisdom of your caution [in holding cash] . . . There is only one cure for terminal paralysis: you absolutely must have a battle plan for reinvestment and stick to it . . . have a schedule for further [purchases] contingent on future market declines . . . Remember that you will never catch the low . . . seeking for optimality is a snare and delusion; it will merely serve to increase your paralysis.

Words to remember, should things get worse. More on this in days to come. 

One good read

House Stark.