CONTINUING MARKET UPDATE
- Leo Choi
- 5 days ago
- 14 min read
Baoro Research
KEY SUMMARY:
l . Elevated Valuation: Both our IERP and P/CF models suggests the S&P500 is significantly overvalued at current levels (~5,280), with fair value estimates pointing toward the 4,000 – 4,300 range – implying a potential downside of 18 – 25%.
lI. Deteriorating Macro Conditions: Rising inflation expectations, weak consumer confidence, increasing jobless claims, and renewed tariff pressure suggests that the bear steepening of the yield curve is being driven by cost-push inflation rather than economic strength.
lII. Mispricing of risk by the market: If the Implied Equity Risk Premium (IERP) rises to levels seen in past periods of elevated risk—such as 6% or higher—our valuation model suggests the S&P 500 could fall to 4,100 or below, implying a 25%+ decline from current levels.
Introduction
Since our bearish call on U.S. equities in the early weeks of January, the market has declined by approximately 20% from its all-time highs. However, a subsequent bullish rebound has narrowed that drop to around 12% at the time of writing—a move that understandably raises the question for investors: Has the market bottomed, and is it time to reintroduce equity exposure into portfolios?
In this Continuing Update, we argue against that notion and maintain our view that further downside is likely for U.S. equities. We believe the market could still fall to levels consistent with recessionary conditions, and our bear case has strengthened, warranting a repositioning toward a more defensive stance.
We begin by updating our analysis of the Implied Equity Risk Premium (IERP) since our last publication. Our findings suggest that the market may not be accurately pricing in the current level of macroeconomic and financial risk, highlighting a potential underestimation of downside threats given the evolving market narrative. If the IERP were to adjust to levels typically observed during recessions, equity valuations could face further significant pressure. In such a scenario, we estimate a potential additional downside of 25% or more for the broader market.
To validate our outlook, we also apply a valuation approach based on cash flow multiples—where cash flows are defined as the sum of dividends and share repurchases. This alternate method yields results consistent with our IERP-based analysis, reinforcing the case for meaningful downside risk.
Lastly, we incorporate qualitative insights, highlighting key fundamental developments that serve as coincident indicators and further strengthen the conviction behind our market view.
IERP Developments
The Implied Equity Risk Premium (IERP) is a forward-looking measure of the extra return investors demand for holding equities over risk-free assets, derived from current market valuations and expected future cash flows. Unlike historical or survey-based estimates, the IERP reflects real-time market sentiment and pricing, making it a more dynamic and actionable indicator. It serves as a key gauge of the market’s risk appetite—rising when investors are risk-averse and falling when confidence is high. This makes the IERP a fundamentally important variable for identifying mispriced risk and positioning early for directional opportunities in equities and other asset classes.
At the time of our last market update, Implied Equity Risk Premium (IERP) levels were observed in the low 4% range. Since then, the measure has risen to 4.85%. While the recent market sell-off has felt particularly sharp and disconcerting, a historical perspective on IERP levels reveals that current conditions are far from unprecedented. The market has experienced more elevated risk premiums in the past, and today’s environment remains within the bounds of long-term norms. Below is a historical time series of IERP levels for the S&P 500 Index spanning the past two decades:
The mean-reverting nature of the Implied Equity Risk Premium (IERP), as discussed in our latest update, appears to be taking effect, with the measure climbing toward its long-term historical average of 5.39%. While this upward move may indicate a return to more historically consistent valuations, it also brings into focus the implications for index levels as the reversion continues. What we emphasize here is the importance of examining where the index could potentially trade under varying IERP scenarios, particularly as sentiment and risk appetite evolve. By applying analyst consensus forward earnings estimates and incorporating appropriate inputs for estimating the discount rate on future cash flows, we derive the following projections for index levels during this reversion:
Our constant payout valuation framework indicates that a straightforward reversion of the Implied Equity Risk Premium (IERP) to its historical mean of 5.39% would imply a market decline of approximately 10% from current levels. However, the more pressing question investors should be asking now is: what if IERP levels overshoot the mean? In risk-off environments, it's not uncommon for the market to price in materially higher risk premiums.
To assess this, we extend our analysis to consider scenarios where IERP rises by one and two standard deviations above the mean. Given a sample standard deviation of 0.77%, an IERP at one standard deviation above the mean would stand at 6.16%—a level historically associated with attractive long-term buying opportunities in equity markets. These higher-risk-premium scenarios provide useful insight into potential downside risk, valuation compression, and where index levels might settle if broader macroeconomic or geopolitical stressors persist. The following section presents projected index outcomes under these varying IERP assumptions.
Our valuation model indicates that, should IERP levels rise to 6.16%, one standard deviation above the historical mean, the implied index level would fall to approximately 4,155. This scenario leads to a potential market decline exceeding 25%, assuming current forward earnings estimates and discount rate input remain unchanged. It is important to underscore that such a repricing reflects elevated risk aversion and a more cautious stance by investors toward future cash flows.
However, this projection is based on a static cash flow outlook. If a bear case materializes—introducing disruptions to earnings and free cash flows—the intrinsic value of the index could fall even further. This risk is amplified by the inherent limitations in available data: key inputs such as earnings forecasts and macro indicators are updated on a monthly or quarterly basis, introducing lag and ambiguity into valuation models. In periods of heightened uncertainty, these blind spots can materially impact the precision of intrinsic value estimates.
Extending the exercise further, if IERP were to reach two standard deviations above the mean—at 6.92%, a level indicative of extreme risk aversion and historically rare dislocations, the following index level would be implied:
This suggests that if IERP levels were to rise to two standard deviations above the mean—6.92%—the downside risk becomes materially significant, implying a potential market decline of over 40% from current levels. While such an outcome may appear extreme, it cannot be entirely dismissed. Historical precedent supports this view: between September 2010 and September 2011, IERP surged from the low 4% range to the mid-7% range within just twelve months—highlighting how quickly market sentiment and perceived risk can shift under stress.
Taken together, these scenarios reinforce the view that if our bearish base case persists, the equity market still faces considerable downside potential. This, paradoxically, may present an attractive risk-reward setup for long-term investors willing to look beyond short-term volatility. The broader implication is that risk premia expansion continues to pose a structural valuation headwind, but it also offers the potential for meaningful upside once conditions stabilize and the IERP begins to normalize.
However, one lingering challenge remains: determining which IERP level should be used to identify a potential market bottom. Unlike fixed valuation anchors, IERP thresholds are ultimately a function of market psychology, macroeconomic conditions, and investor positioning—making this process inherently subjective. This underscores the “art” side of trading and investing, where judgment, historical awareness, and contextual understanding play a critical role alongside data and models. Fortunately, just like the IERP itself, market history provides a valuable reference point. By studying past dislocations and recoveries, we can better frame expectations and calibrate positioning, even amidst heightened uncertainty.
The Yield Curve
The yield curve represents the difference in interest rates between long-term and short-term U.S government bonds- commonly, the 10 – year and 2- year Treasury yields. Normally, longer-term bonds carry higher yields to compensate for risks of time, resulting in an upward-sloping curve. However, when the yield on 2-year treasuries exceeds that of 10-year Treasuries- a phenomenon known as yield curve inversion which it often signals that investor expectation for economic slowdown or lower interest rates in the future. This inversion has historically been a reliable predictor of recessions because it reflects pessimism about long-term economic growth and tighter monetary policy in the short term.
At the time of this analysis, the yield curve has not only fully inverted but has also begun to exhibit a dynamic commonly referred to as bear steepening. Bear steepening describes a shift in the yield curve where long-term interest rates rise more rapidly than short-term rates, resulting in a steeper curve. The term “bear” signifies a decline in bond prices, particularly in long-duration bonds, as yields move inversely to prices. This phenomenon typically reflects growing investor expectations for stronger economic growth, higher inflation, or a more aggressive tightening cycle by the Federal Reserve.
The transition from inversion to bear steepening is particularly noteworthy, as it often marks a turning point in market sentiment. While an inverted yield curve is a well-known signal of impending economic slowdown or recession, a bear steepening phase can indicate that markets are beginning to price in a future recovery—or at least a pivot from recession fears toward inflation concerns. In this environment, long-term yields rise to compensate for potential inflationary pressures or fiscal imbalances, while short-term rates may remain elevated or lag due to policy inertia. This shift adds another layer of complexity to the current macroeconomic landscape and reinforces the need for careful analysis of both bond market signals and their implications for equity valuations.
When inflation expectations rise, investors demand higher yields on long-term bonds to compensate for the potential erosion of real returns. This repricing dynamic is a core driver of bear steepening in the yield curve. The recent surge in inflation expectations—as measured by the 5-Year Forward Inflation Expectation Rate, which has jumped to 2.20% from previously lower levels that had signaled cooling inflation—has likely intensified this steepening trend.
This shift represents a meaningful re-evaluation of future inflation risk by the market and carries significant implications for asset pricing. Higher long-term yields, driven by inflation concerns, increase the discount rate applied to future cash flows in equity valuations, thereby compressing present values. As a result, risk assets, particularly equities with long-duration characteristics (such as growth stocks or those with earnings concentrated in the future), face increased valuation pressure.
On the growth side of the narrative, the recent deterioration in consumer confidence adds weight to concerns around slowing economic momentum. Consumer sentiment has fallen to levels not seen since the height of the pandemic, signaling increased caution around household spending—a critical component of U.S. GDP. This aligns with recent downward revisions to economic growth forecasts by both major institutions and the Federal Reserve in its latest outlook discussions. These revisions reflect not only tighter financial conditions but also broader uncertainty around the macroeconomic environment.
Additional indicators, such as the recent uptick in Initial Jobless Claims, further support the view that the economy may be cooling. These data points suggest that labor market resilience—one of the key pillars of the post-pandemic recovery—may be softening. Taken together, these signs challenge the notion that the current bear steepening of the yield curve is being driven by optimism about future growth.
Instead, the evidence increasingly points to a cost-push inflation narrative. The rise in long-term yields appears to reflect rising inflation expectations, not due to strong demand, but rather stemming from supply-side pressures. A central contributor to this outlook is the re-introduction of tariffs by the Trump administration, which are raising red flags about renewed disruptions to global supply chains. These policies are expected to increase the costs of goods and services, feeding into broader price instability concerns.
This nuanced shift—from demand-driven inflation to cost-driven inflation amid weakening growth prospects—suggests that the current market environment is being shaped less by reflationary optimism and more by stagflationary risk. It presents a particularly challenging setup for policymakers and investors alike, as rising yields coupled with deteriorating fundamentals create a complex and fragile landscape for risk assets.
This indicates that, if history is any guide, we are likely facing the pre-conditions of a recession—and we are now seeing a near-perfect alignment with the typical setup that precedes one. This forms the central and most critical update we wish to emphasize in this report. Based on these developments, and in conjunction with our earlier valuation framework, there is now sufficient justification to anticipate a further rise in the Implied Equity Risk Premium (IERP)—potentially into the mid- to high-6% range. Such a shift would align closely with the second and third valuation scenarios outlined previously, implying a minimum downside risk of 25% or more from current index levels.
From a price perspective, this suggests that the S&P 500 could find a reasonable bottom somewhere in the 3,700–4,100 range, significantly below its current level of approximately 5,200. However, as noted earlier, this estimate is inherently sensitive to the assumptions embedded in the valuation model—particularly those related to forward earnings and cash flow expectations.
If our model overestimates earnings—whether due to deteriorating business fundamentals, margin compression, or unanticipated external shocks—the intrinsic value of the index could be materially lower than our projections suggest. Conversely, if the current environment is more resilient than reflected in our assumptions, and actual earnings come in stronger than forecasted, the market bottom could be meaningfully higher. This inherent model risk—the potential for material deviation between estimated and actual outcomes—is a valid concern and one that has drawn widespread criticism in valuation analysis.
And quite frankly, that criticism is warranted. Predicting tomorrow’s earnings is already difficult; forecasting discounted cash flows several years into the future compounds that uncertainty significantly. This is precisely why we complement our primary DCF-based framework with a secondary valuation approach, centered around cash flow multiples. In this model, cash flow is defined more tangibly as the sum of dividends and net share repurchases—a capital return measure that reflects realized distributions rather than forecasted earnings.
Multiples Lens
Below is the historical time series of the Price-to-Cash Flow (P/CF) ratio, where cash flow is defined as the aggregate of dividends and share repurchases by the constituents of the S&P 500 Index. This measure provides a practical lens into how investors have historically valued the tangible return of capital to shareholders, offering an alternative to traditional earnings-based metrics that may be more susceptible to accounting adjustments or forward-looking assumptions.
Historically, the average Price-to-Cash Flow (P/CF) multiple for the S&P 500, using cash flow defined as the sum of dividends and share repurchases, has been approximately 23.2x. Currently, this multiple stands at 30x, reflecting a significant premium to historical norms. At the market’s most recent all-time high earlier this year (January), the P/CF multiple peaked at 34x, highlighting how elevated market valuations have become relative to the long-term average.
Just as we questioned the appropriate Implied Equity Risk Premium (IERP) level to assess fair valuation earlier, we now pose a parallel question through the cash flow multiple lens:
What is a reasonable P/CF multiple that accurately reflects current risk and return conditions?
By applying different multiples to the most recent aggregate cash flow data from the S&P 500 constituents, we can reverse-engineer potential fair value levels for the index. This allows us to evaluate how far current pricing may deviate from what would be considered a more neutral valuation environment.
Using the latest cash flow figure and applying a range of plausible multiples—from the historical average of 23.2x to more conservative levels that might reflect a risk-off environment (e.g., 20x or even 18x)—we arrive at the following implied index levels, helping to bracket where the market might reasonably settle under various scenarios of normalized sentiment and risk appetite:
S&P 500 (Targets at Various P/CF multiple)
Scenario: | P/CF x | Price Target |
Average P/ CF | 23.2 x | 4080.49 |
S&P500 (-1 STDEV) | 18.3 x | 3221.03 |
S&P500 (-2 STDEV) | 13.4 x | 2358.57 |
The outcomes across the various scenarios derived from the cash flow multiple approach are no more encouraging than those observed in our earlier scenario analysis based on IERP. Even when applying the historical average P/CF multiple of 23.2x—which we view as a more conservative assumption—the implied price target closely mirrors the second variation of our IERP-based valuation, suggesting a fair value for the S&P 500 near 4,100.
In our view, this convergence across two independent valuation methodologies should carry greater analytical weight. There is a mathematical foundation supporting this logic: any security’s market price can be conceptualized as the weighted average of a range of possible and expected future outcomes. Therefore, when multiple distinct approaches cluster around similar valuation outcomes, it increases the likelihood that these levels reflect a more realistic central tendency. In other words, the more frequently a certain outcome appears across different reasonable valuation models, the more gravitational pull it has on the true intrinsic value.
This convergence not only strengthens the case for caution but also supports the idea that the downside risk we previously identified—potential declines of 20–30% from current levels—should be taken seriously, particularly in the absence of a meaningful positive catalyst to counteract the negative forces currently at play.
Below is a summary table of various scenarios and corresponding target prices for the S&P 500 Index based on both the IERP-based and P/CF multiple-based valuation approaches:
Upon visualizing the output of our valuation estimates across both the IERP-based and P/CF multiple-based approaches, a compelling convergence emerges around an index level of 4,000–4,300. This range appears to represent a zone where risks would be sufficiently priced in to justify the reintroduction of equity exposure within our portfolios. It aligns with both historical valuation norms and plausible downside scenarios under current macroeconomic conditions.
At the current S&P 500 index level of approximately 5,280, this implies a minimum downside risk of over 18%, with the potential for a 25%+ decline under more risk-averse market conditions. While exact timing remains uncertain, this valuation band provides a useful framework for staggered re-entry, especially for longer-term investors looking to reallocate capital at levels that more accurately reflect macroeconomic headwinds, rising risk premia, and uncertainty in forward earnings expectations.
Few Words on Ongoing Qualitative Developments
The U.S. equity markets have recently experienced heightened volatility, driven by a convergence of economic, geopolitical, and policy-related pressures. A key flashpoint has been the Trump administration’s aggressive trade stance, with newly imposed tariffs—such as a 145% duty on Chinese imports and a baseline 10% on goods from most other nations—raising fears of a full-scale global trade war. While the final tariffs implemented were less severe than initially proposed, the chaotic and abrupt manner in which they were executed has undermined market confidence. The ad hoc nature of the rollout has eroded trust—an often underappreciated yet fundamental pillar of capitalism. Trust fuels investment, drives consumption, and anchors the credibility of fiat currencies, which are backed not by physical assets, but by institutional stability and the belief that economic and policy frameworks will function predictably. As this trust frays, the risks to broader financial and economic stability grow.
Simultaneously, the Federal Reserve finds itself in an increasingly paralyzed state. It faces extraordinary pressure from both market participants and political leadership, particularly the Trump administration, which has vocally demanded lower interest rates. Yet the Fed’s tools are constrained. Cutting interest rates might stimulate economic growth and reduce the cost of servicing government debt—a key benefit amid looming debt ceiling debates and rising federal liabilities. However, lower rates could also unleash unintended consequences, such as increased credit-fueled spending in the private sector, which may offset any progress in containing inflation or reducing the government’s debt burden. This creates a sharp disconnect: monetary policy designed to alleviate one part of the problem may end up exacerbating another.
On the flip side, raising rates to combat inflation could depress consumption and investment by tightening financial conditions. This risks pushing the economy toward recession and driving up unemployment—especially dangerous in an environment where consumer spending accounts for nearly 70% of GDP. At the same time, geopolitical tensions, ongoing lawsuits involving former President Trump, and weakening institutional credibility are feeding into a broader erosion of investor sentiment. Consumer confidence has plummeted, with surveys such as the University of Michigan’s index registering lows not seen since the COVID-19 crisis. Markets have responded with steep losses, wiping out trillions in value and marking the worst performance since the 2020 crash.
Overlaying this is the persistent dysfunction surrounding the U.S. debt ceiling. While lowering rates could ease the government’s interest payments, helping to temporarily manage the debt load, the broader fiscal discipline required to address structural deficits remains absent. Political gridlock and misalignment between fiscal and monetary strategies only add to the uncertainty. Without a coherent, coordinated policy approach, attempts to stabilize the economy risk becoming self-defeating.
In this complex and increasingly fragile environment, the Federal Reserve and policymakers face a deeply conflicted set of choices. Stimulating growth may stoke inflation; fighting inflation may cause economic contraction. Meanwhile, trust—the invisible glue that holds together economic expectations, market behavior, and institutional authority—is under strain. As geopolitical risks mount and domestic political divisions deepen, the challenge lies not only in managing economic indicators, but in restoring the foundational confidence that makes modern capitalism, and the financial system that supports it, function effectively.
Conclusion
In summary, our valuation analysis—grounded in both Implied Equity Risk Premium (IERP) modeling and Price-to-Cash Flow (P/CF) multiples—points to a concerning but analytically consistent message: current equity market valuations appear stretched relative to historical norms and prevailing macroeconomic risks. Both models independently converge around an S&P 500 index level of 4,000 to 4,300 as a more reasonable reflection of fair value under present conditions. This convergence strengthens the credibility of our downside assessment and reinforces our conviction that risk remains asymmetrically skewed to the downside in the near term.
With the index currently trading near 5,280, the potential for an 18–25% drawdown cannot be dismissed, especially amid rising inflation expectations, deteriorating consumer confidence, geopolitical tensions, and increased pressure on corporate fundamentals. While valuation tools are not predictive in isolation, they serve as vital anchors during periods of heightened uncertainty—providing the discipline to avoid emotional decision-making and the framework to re-engage with markets when risks appear more adequately priced in.
We believe that the 4,000–4,300 range represents a more attractive entry point for reintroducing equity exposure, offering a better balance between risk and long-term return potential. As always, we remain committed to revisiting these assumptions as new data emerges, but the current evidence suggests that patience, discipline, and valuation-conscious positioning will be key to navigating the path forward.
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