Wall Street often uses the ratio of a company’s share price to its earnings as the measuring stick for whether a stock appears cheap or expensive. According to that metric, the market as a whole had been unusually expensive over the past two years, a period when particularly easing monetary policy influenced the popular view that lower interest rates gave investors few options for stocks.
According to FactSet, even though it fell 16% in early 2022, the S&P 500 ended this week trading at 16.8 times its projected earnings over the next 12 months. This is still above the average multiplier of 15.7 over the past 20 years, but below the recent peak of 24.1 in September 2020.
Concerns about inflation and the way the Federal Reserve will raise interest rates have led to recent turmoil in the markets and provoked vigorous debate over the fair valuation of stocks in today’s environment. According to Dow Jones market data, the S&P 500’s decline through Friday is the worst performance since 1970.
One source of uncertainty is the growing concern that the Fed’s monetary tightening will propel the economy into recession, a scenario in which the equity multiplier typically declines. Higher interest rates reduce the value of companies’ future cash flows in commonly used pricing models. Already, some investors worry that market expectations for corporate earnings are too high, given the economic constraints ahead.
Michael Mulaney, director of global market research at Boston Partners, which manages $91 billion, said he thinks the S&P 500 is fairly valuable based on today’s rates, but expects valuations to drop further.
Equity valuations tend to fall during tight cycles and earnings growth slows during these periods, even during times that are not marked by high inflation. That means investors should anticipate a potentially even more harsh market environment in the coming months.
What’s more, it’s early in the Fed’s cycle, and Mr. Mulaney said he expects the central bank to need to raise its benchmark rate, which is currently expected to curb inflation. By the end of the Fed’s campaign, he expects the S&P 500 to trade at about 15 times its estimated earnings. Add in a downturn, and the market’s valuation is 13 or 14 times earnings potential, he said.
“We are going to be in a volatile market until we get some solid evidence that there has been significant intrusion to eliminate the inflation problem,” Mr. Mullane said.
bubble burst?
The market turmoil has drawn comparisons to the bursting of the dot-com bubble in 2000.
Analysts at Citigroup Inc wrote this week that the US stock market entered bubble territory in October 2020 and is now exiting that bubble, although they noted that equities are not as spread out as during the dot-com era.
Forward multiple earnings climbed to 26.2 times in March 2000. Thereafter in the sell-off, they fell. By 2002, the S&P 500 traded at a low of 14.2 times its next year’s earnings. In 2008, when the country was in a severe recession, the figure reached 8.8.
While some stocks have been spared this year’s decline, technology and other value-added stocks have suffered the most intense pain. The Russell 1000 Growth Index has fallen 24% this year, while its value counterpart is down 8.1%.
Members of Growth Benchmark include Apple Inc., whose shares are down 17% this year; Microsoft Corp., down 22%; Amazon.com Inc., down 32%; and Tesla Inc., down 27%.
The value gauge, by contrast, is headlined by stocks including Berkshire Hathaway Inc., up 3.8% in 2022; Johnson & Johnson, up 3.4%; UnitedHealth Group Inc., down 3.3%; and Exxon Mobil Corp, up 45%.
Tesla shares, for example, entered trading at 120 times the company’s estimated earnings and were priced at about 54 times this weekend, according to FactSet. Exxon Mobil, on the other hand, was trading at 10.5 times future earnings at the end of 2021, a multiplier that has fallen to 9.4.
It is common in some industries for stocks to trade at very different valuations than in other lines of business. Investors are generally willing to pay more for companies that they anticipate will expand rapidly whose growth prospects are more limited. Technology stocks often command rich valuations, while oil and gas companies historically trade at more muted valuations as the industry’s outlook for energy prices is subject to supply and demand and experiences cycles of boom and bust.
“It is certainly the more expensive names that have borne the brunt of the sell-off,” said Mike Stritch, chief investment officer at BMO Wealth Management. A reset on what is fair to pay for valuations in a rising rate environment. Has been done.”
US stocks also look expensive compared to their counterparts abroad. According to data available on FactSet, benchmarks only in Belgium, Portugal and Saudi Arabia, as well as the tech-heavy Nasdaq Composite, are valued higher based on future earnings than the S&P 500. By comparison, Hong Kong’s Hang Seng trades at 9.5 times its estimated earnings, Japan’s Nikkei 225 at 14.3 times earnings and Germany’s DAX at 11.4 times.
This disparity is causing some investors to take another look abroad.
“Even in our US-focused strategies, we have a healthy allocation to international stocks because they are just cheap,” said Eric Lynch, managing director at asset management firm Scharf Investments.
earning equation
Prices are just one component of stock valuations. Other? corporate earnings. When earnings rise and prices remain constant, valuations contract. If earnings decline, it makes stocks look even more expensive at similar price levels.
So far, earnings have been a rare bright spot in a market fueled by inflation data, shifting Fed policy, and headlines about the war in Ukraine and rising Covid-19 cases in China.
With the latest reporting season wrapping up, analysts expect the profits of companies in the S&P 500 to rise 9.1% in the year-ago first quarter, compared to a 5.9% increase in their forecasts for December 31, according to FactSet. For the year, profit is projected to grow 10%, which is an improvement from the 7.4% growth expected at the end of last year.
The strong results are partly the result of unusually high profit margins, which explains why many companies have managed to pass the higher costs along to customers through price increases. Analysts expect the S&P 500 net profit margin to come in at 12.3% for the first quarter, up from the five-year average of 11.2%.
However, some investors are skeptical that margins may continue to rise.
Mr. Lynch of Sharp Investments said, “It does not appear that peak margins will continue. So even if there is no major downturn, we would say that is certainly a very reasonable call that margins will be narrowed and minimized.” Earnings are estimated to be very high.”
There are additional reasons for concern. According to BofA Global Research, this earnings season companies are reporting “weak demand” variations at the highest rate since 2020.
And the increase in 2022 profit projections for the S&P 500 is largely due to brighter expectations for the energy sector, Boffa found. Without the sector, which accounts for less than 5% of the S&P 500, the index’s earnings expectations this year would be lower than at the end of last year, according to bank analysts.
If earnings disappoint, it will make stock market valuations more expensive than before—not another move lower in stock prices.