After a bruising first half of 2022 marked by bear markets and soaring inflation, recent market rallies have been something of a respite.
In the bond markets, the benchmark 10-year Treasury Note yield fell below 3% in the last days of July after topping out at nearly 3.50% in mid-June. Equities, too, got a bounce as the S&P 500 index (SPX) recovered almost half of its 1H 2022 losses (-20.6%), topping out at -12.2% earlier this month.
Monthly stock valuations initially declined in kind, falling off December 2021’s high of 21.2x to a low of 15.2x at quarter end, only to rebound to 17.5x by mid-August—higher than the 10-year average of 16.3x.
Monthly Historical S&P 500 (SPX) 12-Month Forward P/E
9/1/12 - 8/12/22
Why the recent outsized upswing in valuations? It has to do with improved market sentiment一a response to the Fed’s two punishing 0.75% rate hikes (and their effect on inflation), and a possible pivot away from its current hawkish policy stance.
Certainly, news released last week has offered reason for guarded optimism: July’s Consumer Price Index (CPI), a broad measure of inflation, came in at an annual rate of 8.5%, down slightly from 9.1% in June, representing the first decline in a year.
Still, these bursts of enthusiasm may prove to be premature. We believe valuations may still be at risk as ongoing inflation fears and slowing demand continue to challenge corporate earnings.
“Markets may be getting a little ahead of themselves,” said Co-Chief Investment Officer Alex Oxenham. “We don't see signs of a [Fed] policy change just yet, and it’s unclear if the full impact of rate hikes to date have been priced in,” he adds.
Let's take a look at current valuations in more detail.
How Equity Shares Are Valued, in Theory
Established finance theory tells us that the price of an equity share is equivalent to the present value of future earnings (per share) discounted at the rate of expected return. This is sometimes called intrinsic value.
When Treasury bond yields go up, the discount rate used to bring future earnings back to a present value today also increases. A higher discount rate reduces the present value of $1 of future earnings compared to the present value using a lower discount rate.
For example, the present value of $1 across three years using an annual discount rate of 6% is $0.84. If the yearly discount rate increased to 8%, that $1 would be worth only $0.79 today.
The Price-to-Earnings (P/E) Multiple
The price-to-earnings multiple (P/E), a widely used equity valuation measure, captures this relationship between today’s share price and future or forward earnings (typically expected over the next 12 months).
For example, a share with a current price of $20 and future earnings of $2 has a P/E of 20/2 or 10/1, expressed as 10x. That is, today’s share price is 10 times earnings. This means an investor will pay $10 today for $1 of future earnings received over the next 12 months.
What Determines the Price of a Share, in Practice?
Share price is also influenced by market forces, particularly investor sentiment, and others such as supply and demand. Thus, in practice, share price can reflect more than just the discounted value of future earnings and can present as “expensive” or “rich” (higher) or “cheap” (lower) relative to its intrinsic value.
When evaluating a share’s price, the influence of current market drivers must be a key consideration.
How Share Price Can Impact the P/E Multiple
Importantly, share price (P) and earnings estimates (E) don’t always move in concert.
Earnings revisions are generally released quarterly, whereas changes in market forces can occur at any time. Share prices, then, tend to evolve ahead of earnings.
For example, if there’s an increase in the demand for a stock, the price (numerator) will surge, boosting the P/E multiple even though earnings estimates (denominator) remain stable.
Or, if market sentiment grows overly optimistic about future earnings, this can increase the stock price (and P/E multiple) before the market sees upward earnings revisions.
These are both cases of “multiple expansion.”
Current P/E Multiples
As mentioned, recent market sentiment has jumped significantly, which in our view, is a main driver of increased valuations.
MS Market Sentiment Indicator Level
8/15/21 - 8/12/22
Source: Bloomberg/Morgan Stanley.
Likewise, P/Es had declined from recent peaks in the low 20x-range (2020- and 2021-year ends) but have since returned to levels above their 10-year average of 16.3x.
Daily Historical S&P 500 (SPX) 12-Month Forward P/E
8/15/19 - 8/12/22
What Could Lie Ahead
While P/E multiples are expanding, a wider range of economic data seems to tell a different story. For example, the Institute for Supply Management (ISM) Manufacturing Report on Business New Orders has dipped below 50 for the second month, a strong signal the economy is contracting.
ISM Manufacturing Report on Business New Orders
8/15/16 - 8/12/22
Footnote: The ISM Manufacturing Report on Business New Orders is a monthly composite index based on U.S. data compiled from purchasing and supply executives and used as a leading indicator of economic activity. Levels 0-49 indicate economic contraction, with 50 and above indicative of economic growth.
And while Q2 2022 S&P 500 earnings came in at a higher rate than expected一8.7% vs. 4% at Q2 end (at this writing), growth was mainly driven by the energy and materials sectors. Energy, in particular, had an outsized influence with year-over-year growth of +302%. Outside of these categories, however, Q2 earnings dropped into negative territory.
The benchmark earnings indicator, the S&P 500 (SPX) 2023 Earnings Per Share (EPS) Estimate, also provides a convincing data point. Earnings estimates for the S&P 500 index are now declining; signaling negative revisions could be just around the corner, if not here already. Some experts even think the current level of $244.42/share may dip as low as $190/share in the coming weeks and months.
S&P 500 (SPX) 2023 Earnings Per Share (EPS) Estimates
8/15/21 - 8/12/22
And sure enough, the percentage of earnings revisions heading south is increasing, with more likely to follow.
S&P 500 Earnings Revisions & Breadth
1/1/00 - 8/12/22
In short, current valuations may not have priced in these adverse effects of Fed action, lingering inflation, or economic slowing and may be at risk moving forward.
The Market Is Cheaper, but We’re Probably not There yet
At Hilton, we observe valuations carefully and consider them in our investment process. We rely on a broader, disciplined approach grounded in the market cycle and extensive economic analysis to seek to determine when the markets bottom out.
We view valuations within this context as changes in economic growth, and other factors unrelated to growth can impact them significantly. Our recent piece, “Are We Nearing Market Bottom?” discusses this in detail.
Bill Garvey, Co-Chief Investment Officer, elaborates. “Valuations like P/E multiples always play into our risk management.” “Understanding what’s driving them is essential to building out our approach to try to dampen portfolio volatility, protect existing assets, yet be positioned to move when levels are attractive,” he adds.
As always, we will stay focused on what the data tells us and seek to position our portfolios to provide continued opportunities for growth, regardless of market conditions.