The S&P 500 is 14% down from its Jan ’22 all-time high. Despite this, equities are expensive, with a CAPE ratio of 29.35, almost twice the long-term average of 17.01. The macro context of elevated global debt, deglobalization, aging demographics and decarbonization is not changing any time soon and investors may consider the possibility of further decline ahead for equity prices.

From 2009 to 2021, easy financial conditions caused no consumer inflation but significantly inflated equity prices with the S&P 500 CAPE expanding 164% from 15 to 40 (see chart). Those conditions are now in reverse, and higher interest rates, inflation, and supply-side constraints are expected to depress valuations. During the 1965 to 1982 timeframe, also a period of stagnant growth and obdurate inflation, the CAPE declined 70% from 24 to 7. If a similar decline was to play out, the bottom of this bear market would see the CAPE at 12. A stock like AAPL, accounting for more than 7% of the S&P, would slip from the current 29 to 9 on a forward PE basis.

The level and persistence of inflation will be crucial in driving such an outcome. Although inflation is currently declining, it does not mean prices will return to the levels of the past decade. In the previous inflationary regime, there were three distinct waves of inflation and the CPI dipped below 5% twice before resuming its uptrend and making new highs. A major difference with the current regime is the amount of debt in the system. In the 1960-70s US total debt to Gdp was approximately 160% vs 370% today. The debt overhang is a major constraint policy and makes reducing inflation far more challenging than it was in the 1970s.

Stubborn price increases in the mid to high single digit will affect not just policy and the discount of future cash flows but also EBITA margins. A major paradigm shift is ahead for global investors as real returns, rather than nominal, need to be considered; during the aforementioned 1965-1982 period annualized real returns for the S&P 500 were a paltry 0.9%. Dispersions across sectors will become more significant, with declining correlation across sectors, as some industries and companies fare much better than others. Popular index investing strategies, which were critical to multiple expansion over the last decades, will work in the opposite direction, compounding the compression of valuations due to their inherent reflexivity.

A wholesale rethinking of portfolios is in order.