It’s easy to be an optimist when sailing is smooth. The real test comes when things get rough.
That’s where true-believer bulls find themselves as momentum reverses in equity markets, with pro-stock arguments based on everything from valuations to financial conditions suddenly in question as Federal Reserve hawkishness revives. Early returns aren’t great. The S&P 500 is down 5% in three days.
Worried investors are wondering the same thing: Is this the start of the real crash, or will the things that put a floor under the last one keep the new selloff from snowballing? Charts and valuation tables are being dusted off for guidance on whether the levels of mid-June in equities can hold as the low point of the 2022 market.
“It really stems on what you thought the driver was of the rally. So if your belief that the rally was 100% predicated on a Fed pivot, then of course you think you’ll have to change gears and the market’s heading to new lows,” Art Hogan, chief market strategist at B. Riley, said in a phone call. “And if I believed the catalysts had nothing to do with the narrative around a pivot, then I feel convinced that we’ve seen the lows for the year.”
Market Conditions Ease Back
Valuation has been a central plank in arguments that the worst has passed for bulls in 2022. The S&P 500 is trading around 16.4 times next year’s earnings estimates, around the level where it bottomed versus 2022 forecasts 13 weeks ago. The problem with the model is its reliance on analyst predictions. Nobody is quite sure where earnings will land in 2023, and any evidence they’re crumbling would be unwelcome in this nervous market.
“Forward earnings are an enigma at the moment,” said Mike Bailey, director of research at FBB Capital Partners. “Most of the macro trends would suggest some earnings pain next year and we could be at the tip of the iceberg with 2023 earnings down only 3% from peak.”
Earnings in the S&P 500 are forecast to rise 6.4% to $240.50 a share in 2023, according to analyst estimates compiled by Bloomberg Intelligence. A measure of US profit margins just hit the widest since 1950, suggesting that the prices charged by businesses are outpacing their increased costs for production and labor, government data showed this week.
Stocks dropped for the third straight day on Tuesday as traders recalibrated expectations in response to the Fed indicating it will keep raising interest rates to damp inflation. The S&P 500 fell more than 1% and the rate on 10-year Treasuries hovered around 3.10%.
The stock market suffered a shock due to the hawkishness of Chair Jerome Powell’s tone, said a Morgan Stanley team led by Mike Wilson. The second half of the year will be determined by earnings expectations for 2023, in their view, and equity investors should be laser-focused on this risk.
“The equity market became a victim of its own momentum over the past few months as CTAs and other price insensitive buyers drove valuations to unrealistic levels,” they wrote in a note. “While P/Es have come back down, they remain well above fair value based on our equity risk premium framework.”