stock market investing: Powell snub leaves stock bulls facing ruthless valuation math

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

The S&P 500 tumbled 3.4% this week – reversing about half of its rally since mid-October – as Jerome Powell’s relentless fight against inflation and America’s worsening recessionary prospects exposed a valuation background that may only be explained by more Investor pain can be resolved. Rising bond yields are exacerbating a situation where stocks can historically be between 10% and 30% too expensive.

The market’s recent swoon, which has come after two weeks of big rallies, is an unwelcome reminder of the volatility in valuations for those who just piled into one of the fastest moving stocks this year. Last month, investors poured $58 billion in fresh money into equity-focused exchange-traded funds, the most since March, data compiled by Bloomberg shows.

“We are now in the third round of investors playing chickens with the Fed and losing,” said Mike Bailey, director of research at FBB Capital Partners. “Investors now have more roadblocks in their path as the Fed is clearly on the move to rein in the economy while earnings are likely in the early stages of a painful 10% to 20% decline from previous highs.”

Diagram 1 (2)ET STAFF

Tempted by the past few years’ dip-buying successes, bulls have not given up despite repeated failures, including the most recent after Fed Chair Jerome Powell once again dampened optimism about a dovish central bank. Even after a massive valuation correction, stocks are a long way from being screamingly cheap and past the lows of the bear market. At its October low, the S&P 500 was trading at 17.3 times earnings, beating the bottom valuations of all 11 previous drawdowns and surpassing the median of those prices by 30%.

“It’s difficult to find a very strong bullish case for stocks,” said Charlie Ripley, senior investment strategist at Allianz Investment Management. “Obviously the Fed has already done a huge tightening of the economy, but we haven’t seen any significant slowdown from this policy tightening yet. So I don’t think we may have seen the worst yet.”

Of course, valuations are a poor timing tool, and continued growth in corporate earnings could also mathematically provide the way to cure their excesses. But anyone following interest rate and earnings trends would agree that the fundamental backdrop is murky.

While measuring fair market value is obviously an inaccurate science, a technique known as the Fed model, which compares the income streams of stocks and bonds, provides insight into the dangers stock investors face. Under this model, the S&P 500’s earnings yield, the reciprocal of its price-to-earnings multiple, is 1.3 percentage points above what 10-year government bonds are offering, nearly the lowest premium since 2010.

Diagram 2ET STAFF

Should 10-year yields rise to 5% from the current 4.2% – a scenario that is not out of the question as bond traders are betting that the Fed will hike rates above this level next year – the P/E ratio of the S&P 500 needs to slip to 16 from current reading of 18, all else being equal, to keep its valuation advantage intact. Or profits would have to increase by 15%.

However, betting on such a big win boost goes a long way. Analysts have estimated earnings for the S&P 500 will rise 4% over the next year. Even that, many investors say, is overly optimistic.

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

In other words, what looks like a reasonably priced market can prove expensive if the rosy prospects don’t materialize. Based on $198 per share, the S&P 500 is trading at a multiple of 19.

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

Diagram 3ET STAFF

The dark camp has bond investors on its side. In a mounting warning of a recession, the 2-year government bond yield continued to rise versus the 10-year note this week, reaching levels of extreme inversion not seen since the early 1980s.

Navigating the 2022 market has been painful for bulls and bears alike. With the S&P 500 plummeting 25% from peak to trough, reaping gains as a short seller meant enduring seven episodes of rallies, with the biggest gain coming in at 17%.

The index has seen monthly movements of at least 7.5% in five different months — two up and three down. Not since 1937 has a whole year seen so many dramatic months.

The large swings reflect conflicting narratives. While manufacturing and housing data point to an economic slowdown, a recovering labor market is pointing to consumer resilience. With the Fed depending on incoming data to set the monetary policy agenda, the outcome window is wide open between a slowdown in growth and a serious contraction.

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

He’s not the only one getting wary. Money managers reduced equity exposure to record lows last month on recession fears, while their cash holdings declined, according to the latest Bank of America Corp. survey. reached all-time highs.

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

https://economictimes.indiatimes.com/markets/stocks/news/powell-snub-leaves-stock-bulls-facing-ruthless-valuation-math/articleshow/95315186.cms stock market investing: Powell snub leaves stock bulls facing ruthless valuation math

Russell Falcon

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