As we move deeper into summer, many families will hit the road for summer vacation. For anyone who makes those long drives, or ever has, this inevitable question will be familiar: Are we there yet?
Today’s market turmoil is also causing investors to ask: Is the selling over? Are we there yet?
The odds of a hard economic 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 if the foundation is set for a potentially durable bottom.
Where the U.S. equity market ultimately troughs will depend upon how well the economy holds up and where earnings head. Coming into the year, we expected tough sledding, but we did not expect the economic backdrop to deteriorate as quickly as it has over the past few months.
Our resulting shift in thinking can be described by this quotation, which has been attributed to various people: “When the facts change, I change my mind. What do you do, sir?”
History suggests further digestion may be necessary to sustain upside later. This bear market has run six months, so far, with investors enduring a -23.6% drawdown in the S&P 500 Index from January 3 to June 16. The pain may have felt severe, but bear markets tend to last 16 months and experience a 35% drawdown, with recessionary periods faring worse than non-recessions.
Most bear markets have two components: multiple adjustment and earnings contraction.
Declining price/earnings ratios (P/Es) typically kick off bear markets, with lower P/Es following in every U.S. Federal Reserve tightening cycle. This has been playing out in 2022: the S&P 500 forward P/E contracted from 21.3x moving into January to 15.8x today. This de-rating rivals some of the largest six-month declines in modern history.
Yet multiples could fall further. Historically, the average trough P/E in bear markets was 11.9x. Over the last 20 years, major market lows on average bottomed at 14.4x, due in part to lower interest (discount) rates.
Bear markets also usually feature earnings contraction. This bear market has been driven by P/E compression, while forward earnings expectations have risen a healthy 7.4% this year.
Earnings revisions have started to drift lower. There is a strong possibility of more meaningful downward revisions moving through the back half of 2022. Ultimately, the degree to which earnings expectations decline may determine the severity of the economic slowdown.
To evaluate this dynamic, we track the ISM Manufacturing PMI, which tends to lead S&P 500 earnings by six months. In bear markets after Fed tightening cycles, the ISM often fell below 43, a level consistent with double-digit earnings declines. Should this relationship hold, the market could experience new lows.
With inflation elevated and maximum employment achieved with unemployment below 4%, the Fed increasingly fears that inflation expectations will unanchor. Its research supports the idea that the longer inflation remains elevated, the greater that risk.
To the Fed, the risks of doing too little to tame inflation are far greater than the risks of doing too much.
This thinking has driven a dramatic shift in U.S. monetary policy, moving from expectations of three 25 basis point rate hikes to slightly more than 13 today, implying a Fed funds rate of 3.25% to 3.5%. This would be the second-fastest bout of first-year monetary tightening in 65 years, trailing only 1980, when Fed Chair Paul Volcker broke the back of double-digit inflation.
Bear markets are never joyful, but it is important to remember they are both rare and typically provide excellent opportunities for patient, long-term investors. The market’s bottom will be determined only in hindsight. By the time it has become obvious, equities may have climbed well off 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 trepidation caused by these uncertainties and 2022’s rocky start, visibility is likely to improve in the next two quarters.
Yet U.S. equity investors still may not be able to say “we are there” for some time.
Jeffrey Schulze, CFA
CFA
Any information, statement or opinion set forth herein is general in nature, is not directed to or based on the financial situation or needs of any particular investor, and does not constitute, and should not be construed as, investment advice, forecast of future events, a guarantee of future results, or a recommendation with respect to any particular security or investment strategy or type of retirement account. Investors seeking financial advice regarding the appropriateness of investing in any securities or investment strategies should consult their financial professional.
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