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Given the S&P 500's over 16% decline since the start of 2022, you might think this is a buying opportunity. Don't be fooled.

Big cap stocks are still substantially overpriced for a basic reason: Corporate earnings mushroomed to bubble proportions because of the spending frenzy that raged in the rebound from the pandemic. Now, the balloon is leaking air as a parade of big names announce disappointing results and/or forecasts, among them Walmart, Target, Amazon, Meta Platforms, Netflix, Nvidia, and Snap. Still, some investors, reassured by Wall Street's buy-side analysts, are clinging to the view that last year's gigantic earnings have more or less set a new, super-elevated base for the future. Hence, they're not slicing prices nearly enough to account for the sharp descent to much more stable earnings levels that's already underway, and set to gather speed.

For investors who are trying to figure out a "fair value" for today's S&P 500, and to estimate where the index is likely to settle in six months or a year, it's crucial to determine when S&P earnings will reach a plateau that will have some staying power. In this analysis, I use a few tried-and-true metrics to establish that number. The distance between the S&P current valuation, and what the underlying fundamentals say it's worth, may shock you.

Tracking the earnings explosion

From the close of 2017 through the end of 2021, corporate profits enjoyed their biggest four-year rise—measured from an already reasonably high start—in more than a century. S&P 500 earnings-per-share jumped from $109.88 to $197.87, or 80%, garnering annualized gains of 17%. In the same period, the U.S. economy expanded by 17.7%, meaning, in essence, that S&P 500 companies' profits outpaced the production of goods and services they were selling by four-and-a-half times. It's notable that the 2021 EPS number was almost half-again higher than the record set in pre-COVID 2019, itself a banner year for earnings. In Q4 of last year, operating margins hit an incredible 13.4%, far above the median of around 9.5% over the past eleven years.

The just-published Fortune 500 rankings vividly illustrates the trend: For 2021, the members posted $1.8 trillion in earnings, a huge gain of over 50% in total earnings versus 2019.

Corporate America can't conceivably maintain that super-rich level of profitability. Earnings clearly need to reset, but where will they land? An excellent yardstick for determining a normal, "reversion to the mean" level for earnings-per-share—a footing from which profits can reasonably grow in tandem with the economy–is the cyclically adjusted price-earnings ratio or CAPE developed by Yale economist and Nobel laureate Robert Shiller. The CAPE measures whether stocks are cheap, expensive or reasonably priced by using a five-year average of earnings-per-share, adjusted for inflation. That formula raises PEs when they're artificially depressed by the kind of temporary earnings explosions we've seen recently (as well as accounting for unreliably inflated multiples when profits hit a short-lived slump).

As of today, the CAPE smoothing formula puts ten-year earnings for the S&P 500, on average, at $128.50 That figure, however, requires an adjustment before it's compared with today's reported EPS. The CAPE marks up past profits to account for inflation, but not for "real" increases that exceed the trajectory for the Consumer Price Index. A rule of thumb used by a prominent investment firm that has strong academic grounding raises Shiller number by 10% to account for the "real" component. Taking the mid-point of 8.75%, the CAPE's "sustainable" earnings come to around $141.

That figure is still 26% lower than the Q4 reading of $198. It implies that EPS was already a bit overheated when it reached an all-time high of $139 at the end of 2019, and was poised to flatten before the COVID economy launched the moonshot.

The almost-always overly optimistic Wall Street analysts are predicting an annualized a decline to $186 for Q2. Keep in mind that today's heavy inflation will play a big part to hammering "real" earnings. The 2% decrease the analysts' forecast is more like a negative 10% in inflation-adjusted numbers, given that the CPI is advancing at an annual rate of over 8%.

The right multiple for lower earnings

At the end of 2017, just as profits took off, the S&P's price-to-earnings multiple stood at 24.3. The next four years witnessed an amazing phenomenon: EPS jumped 90%, and the S&P increased by almost an identical amount. By New Year's Eve of last year, the multiple had barely budged, to 24.1. Still, that would be a pretty high number, even if the numerator were average rather than Brobdingnagian profits. The S&P's median P/E since 1988 is 21.8, which in turn is well above the average of around 16 when the benchmark index measured for more than a century.

At the market close on May 25, the P/E had fallen to 20.1, driven lower by the year-to-date fall of over 16%. That slightly-below-average multiple might make stocks look somewhat cheap. But once again, it's swelled by a denominator of still-highly-inflated profits.

We can arrive at a reasonable forecast of fair value for the S&P by deploying the Shiller earnings number (after our upward adjustment for "real" gains), and the average P/E over the past thirty-three years. A multiple of 21.8 applied to earnings-per-share of $140 would make the S&P reasonably priced at 3080. That's 22% below its close of 3970 on May 25. The basics are clear: The S&P is still hovering over a big air pocket.

A markdown in EPS by nearly one-quarter, the top factor is establishing a fair value well below today's levels, might seem extreme. But that's not the case. At $141, earnings would still be 28%, or 6% a year, higher than they were at the end of 2017. At that starting point, operating margins were already elevated at 10.3%.

At a fair value of around 3100, the S&P would still stand close to its then-record following years of outsized gains at the end of 2019, and up 38% from the beginning of 2017.

A fall of 22% isn't even particularly pessimistic. That scenario still projects that the market P/E will settle at almost 22, a high number by historic standards. It will only be that high if the markets continue to benefit from the extremely low real interest rates that have provided a big boost in the last decade. Multiples will also be far lower if the Federal Reserve fails in its campaign to quickly tame inflation. A fast-rising and volatile CPI vexes investors who fear the Fed will need to crack down even harder, causing a severe recession. For comfort, they demand a super-fat "equity risk premium," the extra expected returns on stocks versus risk-free bonds, as compensation for the heightened risk of holding equities. The risk-premium cushion only gets bigger when stocks get cheaper. Either persistently high inflation or a return to 2%-plus real rates would compress multiples, making stocks' dive much faster and steeper.

And we're not even talking about a possible recession that would push corporate profits well below the already much reduced number that's reliable. One of the stock market's few certainties is that its drivers eventually revert to the mean, governed by such gravitational forces as overall economic growth and competition that imposes a cap on profitability. Equities can thrive again. But the math shows that they'll have to fall a long way from here before investors will get a genuine buying opportunity.