There is only one brick left to keep standing in real estate stock investing. When the S&P 500 index briefly entered a bear market earlier this month, it was because equity investment valuations had tanked. But the scenario could have turned out much worse if the only other factor that has been propping up equity investing had not held firm. The problem is that there are reasons to believe that it won't last much longer.
Why did falling valuations drag down stock investing?
The US Federal Reserve has entered one of its most aggressive rate-hiking cycles this year in a bid to combat the highest inflation recorded in more than four decades. These higher interest rates (and the resulting jump in bond yields) have depressed equity investing valuations, especially among investing in the more expensive-looking growth stocks that have come to dominate the equity market. investment in US stocks. The graph that we can see below is prepared with data from Absolute Strategy Research, it shows the change of 12 consecutive months in the price-earnings ratio (P / E) final of the S&P 500, that is, the relationship between the market value of the index and its profits over the last 12 months. The rise, or “expansion” in 2020, largely as a result of an avalanche of stimulus packages unleashed by governments and central banks to deal with the pandemic, was the fastest on record and has now been followed by the most extreme. compression” on the record, giving up 2020 benefits and then some.
The S&P 500 has seen its largest year-over-year decline in valuation (as measured by trailing P/E) on record. Source: Bloomberg.
In the following chart we can see the sharp drop in the forward P/E of the S&P 500, that is, the relationship between the market value of the index and its forecasts over the next 12 months.
After the highs of 2020, the P/E of the S&P 500 has returned to its XNUMXst century average. Source: Bloomberg
While the forward P/E could certainly drop further, most of the valuation-driven sell-off is arguably over, with the P/E ratio now back to its 21st century average. The question now is whether the earnings estimates on which those numbers are based are accurate, because that's all that's keeping you invested in stocks now.
Are the latest earnings forecasts accurate for stock investing?
Despite all the recent pessimism surrounding stock investing and the US economy, analyst forecasts point to uninterrupted US profit forecasts for this year, 2023 and 2024. .
Analysts still expect US profits to rise despite recession fears. Source: Goldman Sachs Investment Research
In fact, S&P 500 earnings forecasts are up 3% so far this year. It is true that this is mainly due to the investment in energy company shares, which are benefiting from rising oil and gas prices. If we exclude these actions, the forecasts are practically flat. But even that is unusual: the norm is for estimates to drop a bit mid-year following standard corporate practice of companies lowering the bar as they get closer. What's even more unusual is that this year's earnings forecasts haven't budged despite all the headwinds they've faced. Runaway inflation will hurt consumer demand and business income, higher rates will drive up financing costs, higher wages will reduce profit margins, a stronger dollar will reduce the value of foreign profits, and so on.
Inflation has skyrocketed across all sectors of stock investing. Source:OECD
Not surprisingly, hedge fund managers became extremely pessimistic about earnings prospects in a recent Bank of America survey. Only immediately after the bankruptcy of Lehman Brothers in 2008 did more managers expect overall profits to fall.
Expectations of global returns from investing in stocks are at their lowest level since the Lehman crash in 2008. Source: Bank of America Global Fund Manager Survey
So should we be worried about the future of stock investing?
If profit expectations turn out to be too high, at least one of two things can happen:
- Companies will miss those earnings estimates (leading to more stock sell-offs).
- Poor profit forecasts when investing in stocks cause declines.
If it's the latter, that means there's room for stock investment prices to fall further without necessarily compressing your valuation expectations - i.e. assuming a constant P/E, a drop in earnings is met with a drop proportional in prices. Stock investment valuations are down, but earnings estimates are not. So whether analysts lower estimates or companies end up missing them, stock investment prices could go down. For now, it's best to keep our stock investment exposure low and be prepared until we start to see earnings estimates revised downwards.