There’s Just One Brick Left Keeping The Stock Market Standing

There’s Just One Brick Left Keeping The Stock Market Standing
Reda Farran, CFA

over 1 year ago3 mins

  • The US stock market’s selloff this year was driven entirely by a contraction in valuations on the back of the Fed’s aggressive rate-hiking campaign.

  • This year’s earnings expectations for the S&P 500 have mostly remained flat, despite the growing headwinds facing companies and the economy.

  • Whether analysts end up downgrading their profit estimates or companies end up missing them, stock prices could be headed lower.

The US stock market’s selloff this year was driven entirely by a contraction in valuations on the back of the Fed’s aggressive rate-hiking campaign.

This year’s earnings expectations for the S&P 500 have mostly remained flat, despite the growing headwinds facing companies and the economy.

Whether analysts end up downgrading their profit estimates or companies end up missing them, stock prices could be headed lower.

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When the S&P 500 briefly entered a bear market earlier this month, it was because stock valuations have been cratering. But the scenario could’ve played out much worse if the single other factor that’s been propping up stocks hadn’t held firm. The trouble is, there are reasons to believe it might not hold out much longer.

Why did falling valuations drag down the market?

The US Federal Reserve has embarked on one of its most aggressive rate-hiking cycles ever this year in an attempt to combat the country’s hottest inflation in over four decades. Those higher interest rates (and the resulting jump in bond yields) have knocked down stock valuations, especially among the more expensive-looking growth stocks that have come to dominate the US stock market.

The chart below, conducted using data from Absolute Strategy Research, shows the rolling 12-month change in the S&P 500’s trailing price-to-earnings (P/E) ratio – that is, the ratio of the index’s market value to its profits over the past 12 months. The upward surge, or “expansion”, in 2020 – largely the result of a flood of stimulus packages unleashed by governments and central banks to deal with the pandemic – was the fastest on record, and it has now been followed by the most extreme “compression” on record, giving up 2020’s gains and then some.

The S&P 500 has experienced its biggest year-on-year fall in valuation (as measured by trailing P/E) on record. Source: Bloomberg
The S&P 500 has experienced its biggest year-on-year fall in valuation (as measured by trailing P/E) on record. Source: Bloomberg

Now, this next chart shows the sharp drop in the S&P 500’s forward P/E – that is, the ratio of the index’s market value to its forecasted profits over the next 12 months.

After 2020’s extremes, the S&P 500’s forward P/E is back to its 21st century average. Source: Bloomberg
After 2020’s extremes, the S&P 500’s forward P/E is back to its 21st century average. Source: Bloomberg

While the forward P/E could certainly go lower still, the bulk of the valuation-led part of the selloff is arguably over, with the P/E ratio now back to its 21st century average. So the question now is whether the profit estimates on which those multiples are based are accurate, because that’s all that’s keeping the stock market upright now.

… Do the latest profit estimates look accurate?

Despite all the recent gloom hanging over markets and the US economy, analysts’ forecasts point to uninterrupted gains in US earnings for this year, 2023, and 2024.

Analysts still expect US earnings to rise despite recession fears. Source: Financial Times
Analysts still expect US earnings to rise despite recession fears. Source: Financial Times

In fact, S&P 500 earnings expectations have actually risen 3% so far this year. Admittedly, this is mostly thanks to energy companies, which are benefitting from sharply higher oil and gas prices. Exclude them, and the forecasts are virtually flat. But even that is unusual: the norm is for estimates to be down somewhat by the middle of the year following the standard corporate practice of companies lowering the bar as they approach it.

What’s even more unusual is that this year’s profit estimates have not budged despite all the earnings headwinds that have popped up. Sky-high inflation will dent consumer demand and corporate revenues, higher rates will increase financing costs, bigger wages will shrink profit margins, a stronger dollar will lower the value of foreign earnings, and so on.

It’s no surprise to see professional fund managers turn extremely bearish about the profit outlook in a recent Bank of America survey. Only in the immediate aftermath of the Lehman Brothers bankruptcy in 2008 did a greater proportion of investment managers expect global profits to fall.

Global profit expectations by professional fund managers are at their lowest since Lehman’s bankruptcy in 2008. Source: Bank of America Fund Manager Survey
Global profit expectations by professional fund managers are at their lowest since Lehman’s bankruptcy in 2008. Source: Bank of America Fund Manager Survey

So should you be worried?

If profit expectations indeed prove to be too high, at least one of two things will happen: companies will come up short of those profit estimates (leading to more stock selloffs), or those forecasts will start to come down. If it’s the latter, that means there’s room for share prices to fall further without necessarily compressing their valuation multiples – that is, assuming a constant forward P/E, a drop in profits is met with a proportional drop in prices.

The bottom line is this: stock valuations have come down, but profit estimates haven’t. So whether analysts end up downgrading those estimates or companies end up missing them, stock prices could be headed lower. So for now, it could be best to keep your stock market exposure low, staying on the sidelines in cash (for example) until we start to see profit estimates revised downwards.

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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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