The nearly 20% drop in the S&P 500 this year has been driven, of course, by soaring interest rates as the Federal Reserve tackles the worst inflation in 40 years, driving up costs borrowing and making equities a little less attractive relative to fixed rates. -income investments.
Bonds and stocks typically compete for investor attention, and for years bond yields had become so meager that stocks seemed to be the only game in town. Stocks don’t work quite like bonds, but for comparison purposes, you can estimate their implied “yield” by dividing their projected earnings by their price – the inverse of the price-earnings ratio. During the pandemic, as bond yields bottomed out, equities looked relatively attractive.
That changed this year when the Fed pledged to get aggressive on inflation and bonds fell, pushing yields higher. The spread between the S&P 500 earnings yield and the 10-year Treasury fell to a 14-year low. It was natural for this spread to approach something in line with the historical average. Now, the future depends on what happens with corporate earnings assumptions embedded in earnings performance and whether investors think bond yields could rise further.
Consider the earnings outlook first. According to Nicholas Colas, co-founder of DataTrek Research, signs are emerging that the United States is headed for economic contraction and corporate profits typically decline by around 25% during a recession. Analysts are a long way from factoring this into their earnings outlook. In fact, data compiled by Bloomberg shows that adjusted earnings per share are expected to rise another 10.4% in 2022 to $227.40 per share and another 7.5% to $246.30 per share in 2023. .
As Colas wrote on Friday, even a “milder than most” downturn could see earnings drop about 15% to around $188 per share, and a full-scale recession would look more like $166 per share. Apply a multiple of 18 times the slightly more generous than average earnings at these levels, and you land at an S&P 500 level of around 3,386 for the mild recession scenario and 2,970 for the darkest. (The S&P 500 closed Friday at 3,825.33.)
Of course, earnings are not the only variable, and it is possible that interest rates could drift higher, which will put further pressure on bond and equity valuations. Obviously, the key is inflation, which Fed Chairman Jerome Powell has pledged to crush even if it causes collateral damage. In recent days, the bond market has taken signs of a slowing economy to mean that the Fed could divert attention from inflation and focus instead on preserving jobs, the other part of the Fed’s mandate. the Fed. But that’s not the message Powell has been projecting recently.
At a forum in Portugal, he said he recognized the risk that the Fed’s interest rate campaign could hurt the economy, but said “the biggest mistake to make – let’s say as well – would be to fail to restore price stability”. It is possible that markets will misinterpret the Fed’s determination to fight inflation even in the face of slower or negative economic growth and that the stock market will be hit by a double whammy in interest rates and earnings at the during the second half of the year.
Admittedly, the balance of risk is not completely against equities. The runaway inflation that has plunged the economy into this quagmire and catalyzed the market sell-off may well begin to resolve itself in the coming months: Loosening supply chains and rising inventories could lead retailers to lower prices, while a ceasefire in the war in Ukraine could cause a rapid reversal in commodity prices. Both have already started performing to some extent and may continue. It wouldn’t solve all of the country’s inflation, but it would certainly allow the Fed to approach the situation with a lighter touch. But in the meantime, Burry is right on the base case: As bad as this year is, there’s plenty of reason to believe there’s more pain to come.
More other writers at Bloomberg Opinion:
• Markets signal Pyrrhic inflation victory: John Authers
• Average investors should try and time the markets: Jared Dillian
• Playing in the world of post-peak rates is no easy task: John Authers
This column does not necessarily reflect the opinion of the Editorial Board or of Bloomberg LP and its owners.
Jonathan Levin has worked as a Bloomberg reporter in Latin America and the United States, covering finance, markets, and mergers and acquisitions. Most recently, he served as the company’s Miami office manager. He holds the CFA charter.
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