The Market Just Turned An important Corner
There are a few big reasons why the market may now be ready to find its footing.
After the wild ride of the last few weeks—and with the S&P 500® now down 19.9% on an intraday basis—we have finally reached what I think is an important crossroads. Let's dig into a few reasons why stocks could find their footing from here, plus one of the major risks that remains.
In my opinion, stocks are now fairly valued
As I have written before, personally I believe that the stock market correction has been a "valuation reset"—or a recalibration of price-earnings (P/E) ratios—driven by the anticipation of higher interest rates. If that is the case, then after the S&P's decline this year, the stock market is just about back to fair value.
As of last week's low point, the forward P/E ratio (meaning price divided by estimated earnings for the next 12 months) was down to 16.6, a decline of 6 points from its recent high of 22.7 last year. Meanwhile, the trailing P/E ratio (meaning price divided by reported earnings for the past 12 months) was down 10 points from its high.
Depending on how you slice the numbers, one could argue that stocks are still slightly overvalued compared with earnings. For example, there is still a gap between the 65% gain in the S&P monthly total return index since March 2020 and the 54% gain in earnings per share over the same period (implying that stock prices have raced slightly ahead of earnings during that period).
But there are other ways to slice the numbers. For example, the 65% S&P monthly total return index gain lines up closely with the 68% projected earnings-per-share gain through the end of calendar year 2023 (again, using March 2020 as a starting point). On that basis the valuation reset could be considered complete. However, if we're saying that stocks are fairly valued against next year's earnings, it would imply that we may be looking at a sideways market between now and 2023.
Expected inflation rates are falling
Even though last week's consumer price index (CPI) report came in hotter than expected, there seems to be a growing consensus that the rate of change in inflation has peaked. If that's true, from here it is mostly a matter of how far the inflation rate will fall before it settles. Will it be 5%, 4%, 3%, or something else?
While the CPI measures the pace of the inflation we've already experienced, expected inflation is at least as important to markets. As of last week, expected inflation over the next 10 years had fallen to 2.68%, as measured by breakeven inflation rates on Treasury Inflation-Protected Securities (TIPS). Below, you can see the numbers sliced another way, with the future inflation rate that investors expect to prevail 5 years later (again, using breakeven inflation rates implied by comparing current yields in the TIPS and Treasury markets). That rate has now fallen to about 2.35%, close to the roughly 2.5% level it held about a year ago.
This suggests that long-term inflation expectations are contained. This is a critical nuance for the Fed, as it reduces the likelihood of spiraling inflation and means the Fed could reach the end of its rate-hike cycle sooner (i.e., at a lower interest-rate level) than it otherwise might have to.
The market now looks oversold
On top of these developments, the market now looks oversold on a technical basis. As of last week's low, the market reached oversold levels similar to the other corrections that have occurred since the March 2020 low. While we are not quite as oversold as we tend to get at major market bottoms like 2009, this decline seems adequate for a valuation-reset correction.
Investor sentiment is generally a contrarian indicator. And with the market's decline this year, it's no surprise that investors are feeling gloomy. Below we see that the American Association of Individual Investors (AAII) survey shows significantly more bears than bulls.
Other contrarian measures also suggest we may be turning a corner. After 2 years of inflows, investors are now pulling money out of stock mutual funds and exchange-traded funds. Margin debt is now shrinking again, after spiking in 2020.
Finally, corporate insiders (who tend to buy their company's stock when they think it's undervalued, and sell when they believe it's overpriced) are now nibbling again. All in all, this seems to add up to a tradeable low, in line with past periods of Fed-induced volatility.
One main risk that remains
Of course, this perspective rests on the thesis that the correction has been a "valuation reset"—repricing an overvalued market. If, on the other hand, you believe that in addition to a valuation problem the market may have an earnings problem, then this reset might not be over. In that case, the question is whether earnings growth will remain intact.
So far it remains so. Earnings estimates for 2022 and beyond continue to rise. Analysts are currently calling for 10.9% earnings growth for 2022, and that number has been solid.
Having said that, earnings growth has clearly already hit its peak for this market cycle and is now declining. The growth rate for trailing earnings per share peaked at 40% last year and is down to 18%, on its way to 10% in 2022.
To be sure, the market can always overshoot to the downside. However, with inflation expectations now falling, perhaps the end is in sight in terms of how high the Fed will push rates.
This could all give investors a better handle on what to expect from here, and perhaps help reduce some of the uncertainty that has been weighing on stocks.