While the S&P 500 index is down approximately 21% YTD, it appreciated 44% from its pre-COVID high in February 2020 to its recent high during January 2022. One could argue that the pre-COVID high of February 2020 was a rich valuation for the index which benefited from years of accomodative Fed policy and low inflation. Risks seem to have increased at every turn since Q4 2019 yet don’t seem to be fully reflected in valuations despite the YTD selloff across indices.
- Pervasive Inflation: Pervasive inflation exists and is likely to exist above the Fed’s 2% CPI target for the remainder of the decade in our view.
- Recession Risk: We believe the U.S. is in a recession. Other analysts are starting to believe that a recession is imminent when previously they believed that recession risk before 2024 was low.
- QT: The Fed ended QE and instituted QT ($95 billion per month run rate by September). The Fed has pivoted from its status as the largest buyer of Government Agency securities to the largest seller, which means that prices for these securities will decline while yields will increase.
- Higher Fed Funds Rate: The Fed will continue to raise the Fed Funds Rate (2-year Treasury yield is approximately 3.20%).
- Weaker Demand: Global demand is softening.
- Greater Geopolitical Risk: Geopolitical risk has increased given the Russian war and elevated tensions with China.
- Elevated Supply Chain Risk: Supply Chain Risk has increased as it relates to sourcing many key goods and various inputs.
Looking at the S&P 500 index, the 2022 PE of 18x (PE calculated on Operating Earnings), is too low. I don’t believe the “E” component of the “PE”. Same goes for the 2023 PE of 17x.
Analysts need to adjust estimates downward. Earnings estimates don’t fully reflect the dual pressures of weaker demand and higher costs (COGS and OpEx). This is true across multiple industries including Information Technology and Consumer Discretionary. Here is the S&P data we reviewed: Click HERE