Stock market investing: Powell’s snub leaves stock bulls facing ruthless valuation calculations

With hopes of a Federal Reserve reprieve dashed, investors are forced to do something they’ve been trying to avoid all year: evaluate stocks on their merits. What they see is not pretty.

The S&P 500 fell 3.4% this week – reversing about half of its rally since mid-October at one point – as Jerome Powell’s unwavering war on inflation and rising recession risks in the United States revealed a valuation backdrop that can only be resolved by more investor pain. Rising bond yields are exacerbating a situation where stocks can be seen as 10% to 30% too expensive based on history.

The market’s most recent slump, coming after two weeks of big rallies, is an unwelcome reminder of the influence of valuations to those who have just piled into stocks at one of the fastest rates this year. Last month, investors poured $58 billion in new money into equity-focused exchange-traded funds, the most since March, according to data compiled by Bloomberg.

“We are now in the third round of investors playing chicken with the Fed and losing,” said Mike Bailey, director of research at FBB Capital Partners. “Investors now have more hurdles in their path as the Fed is clearly on a rampage to slow the economy, while earnings are likely in the early stages of a painful 10% to 20% drop from compared to previous peaks.


Tempted by years of success in bearish buying, the bulls haven’t given up despite repeated failures, including the most recent, which came after Fed Chairman Jerome Powell again stifled the optimism about an accommodative central bank. Even after a massive correction in valuations, equities are far from incredibly cheap, breaking through bear market lows. At its lowest in October, the S&P 500 was trading at 17.3 times earnings, topping the lowest valuations of the previous 11 drawdowns and topping the median of those by 30%.

“It’s hard to find a very strong bullish case for equities,” said Charlie Ripley, senior investment strategist at Allianz Investment Management. “Obviously the Fed has already tightened the economy tremendously, but we haven’t seen a marked slowdown in that policy tightening yet, so I don’t think we’ve seen the worst yet.

Of course, valuations are not a timing tool, and a continued expansion of corporate earnings could also, mathematically speaking, provide the path through which their excesses will be corrected. Yet anyone watching the path of interest rates and earnings would concede that the fundamental backdrop is ominous.

While assessing fair market value is obviously an inexact science, a technique that compares the flow of income from stocks and bonds known as the Fed Model provides insight into the perils facing equity investors. . According to this model, the earnings yield of the S&P 500, the inverse of its P/E ratio, is 1.3 percentage points above what is offered by 10-year Treasuries, nearly the smallest premium since 2010.


If 10-year yields were to rise to 5% from the current 4.2% – a scenario that is not out of the question with bond traders betting that the Fed will raise interest rates above this threshold next year – the S&P 500 P/E ratio would need to slip to 16 from the current reading of 18, all else being equal, to keep its valuation edge intact. Or profits should increase by 15%.

Betting on a big revenue boost like that, however, is a long bet. Analysts estimate that S&P 500 earnings will rise 4% next year. Even that, according to many investors, is too optimistic.

In a client survey conducted by Evercore ISI this week, investors expect large-cap earnings to end in 2023 at an annual rate of $198 per share, or $49.50 per quarter. That’s 18% below the fourth-quarter forecast of $60.54 by analysts tracked by Bloomberg Intelligence.

In other words, what looks like a reasonably priced market can turn out to be costly if the bullish outlook does not materialize. Based on $198 per share, the S&P 500 is trading at a multiple of 19.

“We are still cautious on US equities,” said Lisa Erickson, senior vice president and group head of public markets at US Bank Wealth Management. “We continue to see signs of slowing growth in the economy as well as corporate earnings.”


The dark camp has bond investors on its side. In a growing warning of a recession, the yield on two-year Treasuries continued to rise against 10-year Treasuries this week, reaching a level of extreme inversion not seen since the early 1980s.

Navigating the 2022 market has been painful for both bulls and bears. While the S&P 500 plunged 25% from peak to peak, reaping gains as a short seller meant enduring seven bouts of rallies, with the largest gains of 17%.

Along the way, the index has posted monthly moves of at least 7.5% in five separate months – two up and three down. Not since 1937 has a full year seen so many dramatic months.

Large swings reflect conflicting narratives. While manufacturing and housing data point to an economic slowdown, a strengthening labor market points to consumer resilience. With the Fed dependent on incoming data to set the monetary policy agenda, the results window is wide open between slowing growth and a severe contraction.

Amid the bleak outlook and market turmoil, Zachary Hill, head of portfolio management at Horizon Investments, says his firm has sought safety in consumer staples and healthcare stocks.

He is not the only one to become cautious. Fund managers cut their exposure to equities to record lows amid fears of recession last month, while their cash holdings soared to all-time highs, according to the latest survey from Bank of America Corp.

“We’ve been like this for a while and we need a lot more clarity to get rid of that defensive bias,” Hill said. “We were looking for more certainty in the bond market to feel good about what kind of multiple we need to apply to earnings in this environment.”


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