Written by: Jacob Johnston | Advisor Asset Management
It has been a tough reminder of the impact high inflation and subsequently higher interest rates can have, not only on fixed-income instruments, but equity markets as well. Investors tend to pay less for inflation-juiced (nominal) earnings, so valuations usually fall when inflation rises. This inverse relationship is clear and robust. The S&P 500 was down 20% on a total return basis in the first half of 2022, and the entire drawdown can be attributed to multiple contraction. Corporate earnings (EPS) were relatively stable but the price-to-earnings ratio (P/E), or the multiple applied to each unit of earnings, fell 23%.
The current P/E ratio of the S&P 500 is around 19x earnings. With the sharp drop in valuations and P/E ratios approaching long-term averages one could argue a higher-inflationary environment has been priced in. We would suggest that although equities are cheaper, they are not cheap by almost any metric. A timely rule of thumb in determining whether the equity market is rich or cheap relative to inflation rates is the “Rule of 20.” Since 1970, the sum of the market’s PE and the year-over-year change in the Consumer Price Index (CPI) has averaged 20. Readings above the figure indicates the market is rich, while readings below represent some value. With a P/E of 19x and the June CPI of 9.1% this measure suggests the equity markets are still quite rich with inflation at these levels even with the recent pullback.
Source: AAM, Bloomberg
If inflation remains elevated for a prolonged period further multiple contraction is possible and valuations could remain depressed for some time. We would point to “The Great Inflation” era of 1965–1982 when the average P/E ratio of the S&P 500 was 13x over the 17-year period.
Source: AAM, Bloomberg
On the other side of the valuation equation is profits. As mentioned above, corporate earnings in 2022 have held up reasonably well to this point, thanks in large part to the energy sector. Second quarter earnings season is just getting underway with the S&P 500 expected to grow earnings about 5%, however, excluding energy earnings growth would be negative for the quarter.
Source: AAM, FactSet data
What will be of particular interest is forward guidance. The bottom-up earnings per share (EPS) estimate for the S&P 500 in 2022 according to FactSet is currently $227, a 10% increase from the year prior. Earnings estimates for 2023 hover around $248, a roughly 9% increase over 2022.
Source: AAM, FactSet data
While these estimates have started to tick down (slightly), we anticipate more downward revisions during the second quarter earnings season with the expectation of slower growth ahead as the Fed continues to tighten financial conditions and recession probabilities increase. Assuming valuations hold steady, lower earnings could potentially put additional pressure on equity prices.
Admittedly, this paints a challenging picture for the balance of 2022 and into 2023 when valuations and profits are vulnerable. In this difficult environment we believe the value of professional management is re-emerging and stock selection and sector allocation is critical. We believe it remains prudent to emphasize value and quality factors within equity allocations and would consider companies with resilient earnings that can grow along with or above inflation and that are trading at reasonable valuations. Growth at a reasonable price seems like a winning hand, and we would note in the second quarter earnings estimates charted above that growth can be found in some unfamiliar sectors with energy, industrials, materials and real estate growing faster than the broader market.