US stocks just posted their worst first half since 1970, but the slump was all about the price in price-earnings ratios, according to “The Big Short” investor Michael Burry. “Next up, earnings compression,” Burry, the Scion Asset Management founder, wrote Thursday on Twitter. He’s right about corporate profits, but don’t rule out even scantier multiples as well.
The S&P 500 Index’s nearly 20% decline this year has been driven, of course, by the surge in interest rates as the Federal Reserve moves to tackle the worst inflation in 40 years, driving up borrowing costs and making stocks somewhat less attractive relative to fixed-income investments.
Bonds and stocks generally compete for investors’ attention, and for years the yields that bonds paid had become so meager that equities looked like the only game in town. Stocks don’t work quite like bonds, but for comparison sake, you can estimate their implied “yield” by dividing their projected earnings by their price — the inverse of the price-earnings ratio. During the pandemic, with bond yields hitting the floor, stocks looked comparatively attractive.
That shifted this year when the Fed pledged to get aggressive on inflation and bonds fell, causing yields to rise. The spread between the S&P 500 earnings yield and the 10-year Treasury note fell to the lowest in 14 years. It was only natural for that gap to close to something in line with the historic average. Now, the future depends on what transpires with the corporate profit assumptions embedded in the earnings yield and whether investors think bond yields could move even higher.
First, consider the outlook for earnings. Signs are emerging that the US is headed toward an economic contraction, and corporate profits typically shrink about 25% during a recession, according to DataTrek Research co-founder Nicholas Colas. Analysts are nowhere near baking that into their earnings outlooks. In fact, data compiled by Bloomberg show adjusted earnings per share are still projected to grow 10.4% in 2022 to $227.40 a share and an additional 7.5% to $246.30 a share in 2023.
As Colas wrote Friday, even a downturn that’s “milder than most” could bring earnings down about 15% to around $188 a share, and a full-blown recession would look more like $166 a share. Apply a slightly more generous-than-average 18 times earnings multiple to those levels, and you land at an S&P 500 level of about 3,386 for the mild recession scenario and 2,970 for the grimmer one. (The S&P 500 closed Friday at 3,825.33.)
Of course, earnings aren’t the only variable, and it’s possible that interest rates could drift higher, further pressuring bonds and equity valuations alike. Clearly, the key is inflation, which Fed Chair Jerome Powell has vowed to crush even if it causes collateral damage. In recent days, the bond market has taken signs of a softening economy to mean that the Fed may take its eye off inflation and focus instead on preserving jobs, the other part of the Fed’s mandate. But that’s not the message Powell has projected recently.
At a forum in Portugal, he said he acknowledges the risk that the Fed’s interest-rate campaign could hurt the economy but said “the bigger mistake to make — let’s put it that way — would be to fail to restore price stability.” It’s possible that markets are misreading the Fed’s resolve to fight inflation even in the face of slower or negative economic growth and that the stock market might get hit by an interest rate and earnings double whammy in the second part of the year.
To be sure, the balance of risks isn’t completely stacked against equities. The runaway inflation that sent the economy into this quagmire and catalyzed the market selloff could well start to resolve itself in the months ahead: Easing supply chains and mounting inventories could lead retailers to lower prices, while a cease-fire in the war in Ukraine could lead to a rapid reversal in commodities prices. Both have already started happening to a degree and may continue. That wouldn’t resolve all of the country’s inflation, but it would certainly allow the Fed to approach the situation with a lighter touch. But in the meantime, Burry is right about the base case: As bad as this year has been already, there are many reasons to believe there’s more pain ahead.
Jonathan Levin has worked as a Bloomberg journalist in Latin America and the U.S., covering finance, markets and M&A. Most recently, he has served as the company's Miami bureau chief. He is a CFA charterholder.