Wall Street often uses the relationship between a company’s stock price and its performance as a yardstick for whether a stock seems cheap or expensive. With that measure, the market as a whole had been unusually expensive for much of the past two years, a period when particularly light monetary policy turbocharged the popular notion that low interest rates gave investors few alternatives to equities.
Although it has fallen by 16% to start in 2022, the S&P 500 traded late this week to 16.8 times its expected profit over the next 12 months, according to FactSet. It is still above the average multiple of 15.7 over the last 20 years, but a decrease from a peak of 24.1 recently in September 2020.
Concerns about inflation and the path to Federal Reserve rate hikes have spurred recent market turbulence and sparked a lively debate about appropriate valuations of equities in today’s environment. The S&P 500’s decline to Friday is its worst result to date since 1970, according to Dow Jones Market Data.
One source of uncertainty is the growing concern that the Fed’s monetary policy tightening will tip the economy into a recession, a scenario in which stock multiples usually fall. Higher interest rates reduce the value of companies’ future cash flows in ordinary pricing models. Some investors are already worried that the market’s expectations of corporate profits are too high, given the economic obstacles that lie ahead.
Michael Mullaney, head of global market research at Boston Partners, which manages $ 91 billion, said he thinks the S&P 500 is fairly valued based on current rates but expects valuations to fall further.
The valuation of equities tends to fall during austerity cycles and earnings growth also tends to decline during these periods, even during periods of time that are not characterized by high inflation. This means that investors must anticipate a potentially even tighter market environment in the coming months.
Also, it’s early in the Fed’s cycle, and Mr. Mullaney said he expects the central bank to need to raise its reference rate higher than currently expected to curb inflation. At the end of the Fed’s campaign, he expects the S&P 500 to trade at around 15 times its expected profit. Add a recession, and the market valuation would likely fall to 13 or 14 times profit, he said.
“We will be in a volatile market until we get some concrete evidence that significant intrusions have been made to curb the inflation problem,” Mullaney said.
The bubble burst?
The market turbulence has made comparisons with the dotcom bubble burst in 2000.
Analysts at Citigroup Inc. wrote this week that the US stock market entered bubble territory in October 2020 and is now leaving that bubble, even though they said stocks are not as protracted as during the dot-com era.
Forward multiples climbed as high as 26.2 times the profit in March 2000. In the sales that followed, they plummeted. In 2002, the S&P 500 was traded at a minimum level of 14.2 times next year’s profit. In 2008, when the country was in a severe recession, that figure reached 8.8.
While few stocks have been saved in this year’s fall, technology and other expensive growth stocks have been hit by the most acute pain. The Russell 1000 Growth Index has fallen 24% this year, while its value equivalent has fallen 8.1%.
Members of the growth index include Apple Inc., whose shares are down 17% this year; Microsoft Corp., down 22%; Amazon.com Inc., down 32%; and Tesla Inc., down 27%.
The value gauge, on the other hand, is the headline of stocks including Berkshire Hathaway Inc., up 3.8% in 2022; Johnson & Johnson, up 3.4%; UnitedHealth Group Inc., down 3.3%; and Exxon Mobil Corp., up 45%.
Tesla shares, for example, entered the year trading at 120 times the company’s forecast profit and at the end of this week were priced at around 54 times, according to FactSet. Exxon Mobil, on the other hand, traded at 10.5 times future profits at the end of 2021, a multiple that has dropped to 9.4.
It is normal for shares in some industries to be traded at very different values than those in other industries. Investors are usually willing to pay more for companies that they expect will expand rapidly than those whose growth prospects are more limited. Technology stocks often require rich valuations, while oil and gas companies historically trade at more subdued valuations as the industry’s prospects depend on supply and demand for energy prices and tend to experience cycles of booms.
“It has really been the more expensive names that have been hit by the burden of sales,” said Mike Stritch, chief investment officer at BMO Wealth Management. “There has been a restoration of what is reasonable to pay for valuations in an environment of rising interest rates.”
US equities look expensive relative to their counterparts abroad. Only the benchmarks in Belgium, Portugal and Saudi Arabia, as well as the technology-heavy Nasdaq Composite, have higher valuations based on future profits than the S&P 500, according to data available on FactSet. By comparison, Hong Kong’s Hang Seng traded at 9.5 times its expected profit, Japan’s Nikkei 225 traded at 14.3 times its profit and Germany’s DAX traded at 11.4 times.
That difference makes some investors take a fresh look abroad.
“Even in our US-focused strategies, we have a sound allocation to international equities because they are only cheaper,” says Eric Lynch, CEO of asset management firm Scharf Investments.
The income equation
Prices are only part of the share valuations. The other one? Companies’ results. When revenues rise and prices remain stable, values contract. If profits decrease, it makes shares look even more expensive at the same price levels.
So far, gains have been a rare bright spot in a market rattled by inflation data, shifting Fed policies and headlines about the war in Ukraine and the growing fall of Covid-19 in China.
When the latest reporting season is over, analysts expect earnings from companies in the S&P 500 to rise by 9.1% in the first quarter from a year earlier, compared to their forecasts for 5.9% growth on December 31, according to FactSet. For the year, profit is expected to grow by 10%, an improvement from the 7.4% growth they expected at the end of last year.
The strong results are partly a result of unusually high profit margins, which indicates that many companies have succeeded in passing on higher costs to customers through price increases. Analysts estimate that the S&P 500 net profit margin will end up at 12.3% for the first quarter, above the five-year average of 11.2%.
Some investors are skeptical that margins may continue to rise.
“It simply seems unlikely that peak margins would continue,” said Lynch, of Scharf Investments. “So even if there is not a big, huge recession, we would still say that there is really a very reasonable call to make margins better. Compressed and at least profit estimates are too high.”
There are further reasons for concern. Companies this earnings season have mentioned variations of “weak demand” at the highest rate since 2020, according to BofA Global Research.
And the increase in profit calculations for 2022 for the S&P 500 is largely attributable to brighter expectations for the energy sector, BofA found. Without the sector, which accounts for less than 5% of the S&P 500, expectations of the index’s results this year would have fallen lower from the end of last year, according to the bank’s analysts.
If the result were to disappoint, it would make the stock market valuations even more expensive than they already look – in the absence of a further decline in stock prices.