Stocks Are Way Down. They’re Still Expensive.

US stocks had their worst start to the year in more than half a century. By some measures, they still look expensive.

Wall Street often uses the ratio of a company’s stock price to its earnings as a metric to determine if a stock looks cheap or expensive. By that metric, the market as a whole has been unusually expensive for most of the past two years, a period in which monetary policy has been particularly easy, adding to the prevailing view that low interest rates bring investors a number of alternatives to stocks.

According to FactSet, despite a 16% drop in early 2022, the S&P 500 was trading this weekend at 16.8 times expected earnings for the next 12 months..

This is still above the average multiple of 15.7 over the past 20 years, but down from the recent peak of 24.1 in September 2020.

Worries about inflation and the Federal Reserve’s path to rate hikes have fueled recent market turmoil and sparked heated debate about the appropriate valuation for stocks in today’s environment. . The S&P 500’s decline through Friday was its worst year-over-year performance since 1970, according to Dow Jones Market Data.

One source of uncertainty is growing concern that the Fed’s monetary tightening will push the economy into a recession, a scenario where the equity multiplier typically falls. Higher interest rates reduce the future cash flow value of companies in commonly used valuation models. For now, some investors worry that market expectations for corporate earnings are too high, given the economic headwinds ahead.

Michael Mullaney, global director of market research at Boston Partners, which manages $91 billion, said he thinks the S&P 500 is relatively valued at today’s rates but expects the valuation to further reduced.

Stock valuations tend to decline during tightening cycles, and earnings growth also tends to slow during these periods, even during periods not marked by high inflation. That means investors must anticipate an even harsher market environment in the coming months.

Furthermore, it’s still early in the Fed’s cycle, and Mr. Mullaney said he expects the central bank will need to raise its benchmark interest rate higher than currently expected to contain inflation. By the end of the Fed’s campaign, he expects the S&P 500 to trade at about 15 times its expected earnings. He added that the recession, and the market’s valuation will likely fall to 13 or 14 times earnings.

“We will be in a volatile market until we have some concrete evidence that significant steps have been taken to quell the inflation problem,” Mr. Mullaney said.

Bubble burst?

The market turmoil has been compared to the bursting of the dot-com bubble in 2000.

Analysts at Citigroup Inc.

This week wrote that the US stock market entered bubble territory in October 2020 and is now coming out of it, although they said stocks are not as stretched as they were in the dot-com era.

Forward multiples surged to 26.2 times earnings in March 2000. In the subsequent sell-off, they fell sharply. By 2002, the S&P 500 was trading at 14.2 times the following year’s earnings. In 2008, when the country fell into a severe recession, the number rose to 8.8.

While few stocks have escaped this year’s slump, technology and other expensive growth stocks have suffered the most. The Russell 1000 Growth Index is down 24% this year, while its value counterpart is down 8.1%.

Members of the Growth Standard include Apple Inc.,

their stock is down 17% this year; Microsoft Corp.

, down 22%; Inc.,

down 32%; and Tesla Inc.,

down 27%.

S&P 500 stocks, valuation versus performance










In contrast, the measure of value promoted by stocks including Berkshire Hathaway Inc.,

increase by 3.8% in 2022; Johnson & Johnson,

up 3.4%; UnitedHealth Group Inc.,

down 3.3%; and Exxon Mobil Corp.

45% increase.

For example, Tesla stock entered the year trading at 120 times the company’s expected earnings and this weekend is valued at about 54 times, according to FactSet. Exxon Mobil, on the other hand, was trading at 10.5 times futures earnings at the end of 2021, a multiple that has dropped to 9.4.

It is normal for stocks in some industries to trade at valuations that are very different from those of others. Investors are generally willing to pay more for companies that they predict will expand rapidly than those with more limited growth prospects. Technology stocks typically offer high valuations, while oil and gas companies have historically traded at lower valuations as the industry’s outlook depends on supply and demand for energy prices and tend to experience boom and bust cycles.

“It’s certainly been the more expensive names that have taken the brunt of the sell-off,” said Mike Stritch, chief investment officer at BMO Wealth Management. “There has been a reset of what is reasonable to pay for valuation in a bullish rate environment.”

US stocks also look expensive relative to their overseas counterparts. According to data available on FactSet, only the benchmarks in Belgium, Portugal, and Saudi Arabia, as well as the Nasdaq Composite, have higher future earnings-based valuations than the S&P 500. For comparison , Hong Kong’s Hang Seng traded at 9.5x earnings, Japan’s Nikkei 225 traded at 14.3x earnings and Germany’s DAX traded at 11.4x.

That disparity is causing some overseas investors to take a different look.

“Even in our US-focused strategies, we still have a reasonable allocation to international stocks because they are cheaper,” said Eric Lynch, managing director at asset manager Scharf Investments. .

Income Equation

Price is just one component of stock valuation. What else? Company income. As earnings rise and prices stabilize, valuations go down. If earnings fall, that makes the stock even more expensive at the same price.

Earnings have so far been a rare bright spot in a market rattled by inflation data, Fed policy changes and headlines about the war in Ukraine and the growing Covid-19 case in China. .

As the latest reporting season ended, analysts expected that profits from S&P 500 companies rose 9.1% in the first quarter from a year earlier, compared with their forecast for a growth of 5.9% as of December 31, according to FactSet. This year, profits are expected to grow 10%, an improvement from the 7.4% growth they expected late last year.

The strong results were partly due to unusually high profit margins, which shows that many companies have managed to pass higher costs on to customers through price increases. Analysts estimate the S&P 500’s net profit margin will be 12.3% in the first quarter, well above the five-year average of 11.2%.

The markets have been looking increasingly shaky lately: Stocks, bonds, and cryptocurrencies are all falling as investors struggle to manage volatile global financial markets. WSJ’s Caitlin McCabe looks at some of the reasons behind the recent market frenzy. Photo: Spencer Platt / Getty Images

However, some investors doubt that margins can continue to rise.

Mr. Lynch, Scharf Investments, said: “It doesn’t look like the top margins will continue to hold. “So even without a major recession, we would say there is certainly a very reasonable call to make margins compressed and at least estimate earnings. is too high.”

There are additional reasons for concern. Companies this earnings season mentioned variations of “weak demand” at the highest rate since 2020, according to BofA Global Research.

And the increase in the 2022 earnings estimate for the S&P 500 is largely due to brighter expectations for the energy sector, BofA found. Without the sector, which makes up less than 5% of the S&P 500, expectations for the index’s earnings would have fallen from the end of last year, according to bank analysts.

If earnings are disappointing, that would make stock market valuations even more expensive than they appear to be – without another move down in stock prices.

Write letter for Karen Langley at

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