What’s happening in the stock markets this year is happening in two phases: a dramatic re-pricing and concern over future earnings capability. We haven’t seen this degree of daily swings (or volatility) since the 2009 Great Financial Crisis or the 2001 “DotCom bubble”. Investor concerns ripple through the markets. Let’s examine these two phases to better understand what has occurred and what may lie ahead.
First, markets experienced a Valuation Correction.
Last fall, the market was trading at about 21 times forward earnings. This is measured as the “P/E Ratio”. The historical average for market P/E is in the 16-17 times earnings. in other words, at what price are investors willing to pay a company’s stock based on future earnings? P/E is the Price divided by Earnings. Earlier in 2021 it was 25 times and clearly overvalued! This was largely driven by “accommodative” Federal Reserve policy and by low interest rates, momentum, and individual investor speculation.
Once it became clear the Fed was raising interest rates, we experienced a correction that took the market down just over 10% – the threshold at which we define a correction. Then, Russia invaded Ukraine, energy and food prices skyrocketed, inflation took hold and the markets ratcheted down into Bear Market territory – a decline of 20% from the highs.
This summarizes what we have seen thus far.
Primarily an adjustment in the price you are willing to pay for earnings – the “P” part of the equation. Now the focus is shifting to corporate earnings themselves – the “E” part of the equation.
The market is currently trying to determine if we will have a “Fundamental Adjustment”. As interest rates are climbing at the fastest pace in nearly 40 years, there is a real possibility that the Fed may induce a recession in order to bring down inflation. This makes it much harder for companies to sustain the strong earnings we’ve seen since in the last two years.
Earnings are threatened by higher interest rates, input cost inflation, and higher wages, which all increase costs. To date, companies have passed through these price increases (which we’re all experiencing) but as consumers and companies themselves slow spending, inflation can’t continue forever. So, revenues decline, earnings decline, and recession becomes a higher probability. This spiral is what the market now fears.
Going back to our P/E equation, as E gets smaller, the ratio itself moves higher. With the S&P 500 Indexâ now trading at roughly 3,900 and with CURRENT expected combined earnings of $239, the market trades at about 16 times earnings (3,900/239 = 16). Should earnings instead come in at $200, the market would then be trading at over 19 times earnings – well above historical levels and further price reductions would likely occur, returning valuations to “normal” levels. It is not inconceivable for prices to decline another 10-20% in this scenario.
So, this is not a good time to be a buyer. At Integras Partners, we took gains last Fall when we saw markets overvalued and moved most of the proceeds into direct real estate offerings. When markets fell below the 20% threshold, we sold as we don’t think we’re at the bottom yet.
Getting out and back in is difficult to do well; you have to be right twice – first when to get out and again on deciding when to get in. Many investors get out and “wait for the market to recover” and miss the steepest part of the recovery. We recommend that individual investors who have not already reduced risk stay invested, as the economy is currently in decent shape. We have strong employment, household formation and consumer demand. Should we have a recession it should be shallow and short-lived, and stocks are likely to come back over the next 18-24 months, and we’d hate to see you miss out on the inevitable growth phase when recessions end. Investors with a long-term time horizon remain invested.