As we approach summer, many families will be hitting the road for summer vacation. For anyone who makes these long drives, or has done so before, this inevitable question will be familiar: Are we already there?
The current market turmoil is also causing investors to wonder: is the sell-off over? Are we already there?
The odds of an economic hard landing (and ultimately a recession) have increased dramatically. For market participants, the key questions are whether all the bad news is already priced in and the groundwork is laid for a potentially lasting bottom.
Where the U.S. stock market eventually bottoms out will depend on how resilient the economy is and where earnings go. At the beginning of the year, we expected a difficult period, but we did not expect the economic environment to deteriorate as quickly as it has over the past few months.
Our resulting shift in mindset can be described by this quote, which has been attributed to various people: “When the facts change, I change my mind. What are you doing, sir?”
History suggests that additional digestion may be required to maintain the rise later. So far, this bear market has lasted six months, with investors suffering a -23.6% drop in the S&P 500 index from January 3 to June 16. The pain may have been intense, but bear markets tend to last 16 months and go down 35 months. % decline, with recession periods being worse than non-recession periods.
Most bear markets have two components: multiple adjustment and earnings contraction.
Falling price-earnings (P/E) ratios typically trigger bear markets, followed by declining P/Es with each US Federal Reserve tightening cycle. This happened in 2022: the S&P 500 forward P/E contracted from 21.3x in January to 15.8x today. This devaluation rivals some of the steepest six-month declines in modern history.
Still, the multiples could drop further. Historically, the average P/E in bear markets was 11.9x. Over the past 20 years, major market lows have averaged 14.4x, partly due to falling interest (discount) rates.
Bear markets are also typically characterized by shrinking earnings. This bear market was driven by P/E compression, while forward earnings expectations rose 7.4% this year.
Earnings revisions have started to decline. There is a strong possibility of more significant downward revisions in the second half of 2022. Ultimately, the degree to which earnings expectations decline could determine the severity of the economic downturn.
To gauge this momentum, we follow the ISM Manufacturing PMI, which tends to lead S&P 500 earnings by six months. In bear markets after Fed tightening cycles, the ISM has often fallen below 43, a level consistent with double-digit earnings declines. If this relationship holds, the market could experience new lows.
With high inflation and a peak employment rate reached with an unemployment rate below 4%, the Fed is increasingly concerned that inflation expectations will become unanchored. His research supports the idea that the longer inflation remains high, the greater this risk.
For the Fed, the risks of doing too little to control inflation are much greater than the risks of doing too much.
This thinking has led to a dramatic shift in US monetary policy from expectations of three 25 basis point rate hikes to just over 13 today, implying a fed funds rate of 3.25% to 3 .5%. It would be the second-fastest monetary tightening in 65 years, after only 1980, when Fed Chairman Paul Volcker broke his back on double-digit inflation.
Bear markets are never happy, but it’s important to remember that they are both rare and usually offer great opportunities for patient long-term investors. The bottom of the market will only be determined with hindsight. By the time it becomes apparent, stocks may have climbed well past the lows, with possible false starts along the way.
Many questions remain unanswered regarding inflation, Fed policy, interest rates, recession risk, valuations and earnings. Despite the concern caused by these uncertainties and the difficult start to 2022, visibility should improve over the next two quarters.
Still, US equity investors may not be able to say “we’re there” for some time.
Jeffrey Schulze, CFA
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