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Triumph of the Shill

TUE 28 JUN 2022

It is an obvious point, however, the key components of equity return are; 1) earnings per share; and 2) the valuation multiple. Of course, the latter also incorporates perceptions of risk and the discount rate. Moreover, both factors are reflexive and pro-cyclical. Stated differently, investors (ironically) tend to pay a higher valuation multiple during phases of earnings strength (or cyclical expansion) and lower multiples during profit recessions.

The big picture point is that the “fair” valuation of an equity market or sector boils down to the appropriate P/E valuation multiplied by the forecast EPS integer. For example, if you thought the right P/E was 16.7 (the long term average) and forecast EPS on the S&P500 was say $180 (around 20% lower than current) then the “fair” value for the US stock market would be approximately 16.7 x 180 = 3000 (rounded).

While that might sound catastrophically bearish compared to the current index level of 3,900, recall that the current valuation multiple of 16.5 times forward earnings is close to the long-term average (and equilibrium – chart 1). In bear markets, valuations typically overshoot to the downside. Furthermore, the earnings contraction in a typical recession is 15-20% over the past few cycles (2008 was a lot more). A related observation is that analysts (in aggregate) are poor at estimating earnings recessions at major cyclical inflection points. Although human beings cannot see the future, one should have health dose of scepticism when it comes to earnings forecasts.

From our perch, the recent tightening in financial conditions will probably lead to a non-trivial slowdown in earnings growth over the coming months (chart 2). That observation is supported by the deterioration in manufacturing surveys (new orders to inventory) small business, CEO confidence, housing market and consumer sentiment (as a lead on final demand).

At a high level, earnings growth equals change in profit margins plus change in volumes. Odds are that volumes are likely to slow given the factors just noted and profit margins are likely to be pressured by strong wages and other (known) input cost pressures. On the positive side, some of the commodity price input cost pressures have started to moderate. On the negative side, US profit margins are at a record level (chart 3).

In conclusion, our sense is that the current counter trend (bear market) rally from the low in mid-June is probably one to fade. All of the correction (so far) year to date has been driven by valuation multiple contraction (final chart). The challenge looking forward is that valuation typically overshoots and odds are that earnings will likely be revised lower given the rapid tightening in financial conditions, moderation in volume growth and probable compression in profit margins. On the positive side, the prevailing bias is already rather pessimistic and the inflation/interest rate risk might start to ease later this year. In Asia, valuation and sentiment is even more depressed and financial conditions will likely start to improve in the second half.


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