This year, the stock market had its worst first half in 50 years. The S&P 500, the key benchmark for US stocks, fell 24% and the tech-heavy Nasdaq lost 33% of its value.
The price drop, however, had little to do with corporate finances. (For example, while the S&P 500 cratered in the first quarter of 2020, its earnings rose 4.4% from a year ago). Instead, it was the result of a market phenomenon called “multiple compression.”
In human language, it is a reduction in the price investors are willing to pay for a dollar in a company’s earnings.
According to JPMorgan’s calculations, the first half of 2020 saw the sharpest squeeze in 30 years, beating the dot-com crash and the aftermath of the 2008 housing crash.
“The S&P 500 experienced its second-largest P/E depreciation in 30 years, surpassing the typical compression seen in previous recessions. While the current stock multiple is in line with the historical median, we believe it is better that fairly valued…,” JPMorgan wrote in an internal memo.
The big picture
If not earnings, what has made investors question the price they want to pay for stocks?
Two things: 1) the Fed’s battle against inflation and the Russian-Ukrainian conflict.
Since the beginning of this year, the Fed has made the most aggressive rate hikes in decades to keep inflation close to double digits in check. Such a hawkish Fed does not fare well for risky assets because higher rates increase the cost of borrowing and lower valuations.
Meanwhile, the West’s confrontation with Russia over Ukraine is putting a damper on global energy and food supply chains while fostering the very inflation that central banks are trying to extinguish.
The good news is that the pessimism associated with downgraded valuations may already be behind us.
At the latest FOMC meeting, Powell sounded dovish, hinting at a slowdown in rate hikes. Meanwhile, inflation is showing signs of peaking, which may lead to what JPMorgan calls “a reset in investor expectations.”
“Whether it’s earnings or the Fed, we’re seeing a reset in investor expectations: last week’s more dovish Fed meeting, which saw the base rate lifted near neutral, as well that easing inflation expectations and falling bond yields, indicate that the peak of warmongering is likely behind.Risk markets are rallying despite some disappointing data releases, indicating that bad news was already anticipated/ taken into account,” JPMorgan analysts wrote in an internal memo.
In fact, according to JPMorgan’s internal survey, 58% of its institutional clients plan to increase their equity exposure.
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