The S&P 500 is approximately at its long-term average P/E multiple of 20x (if one looks back to 1964). However, that multiple could go lower should the Fed hold rates higher for a longer period than what many investors expect. Further, markets tend not to bottom until after the Fed begins to cut rates (we are not close to that point yet). In addition to P/E multiple compression, corporate earnings growth could stagnate or go negative due to a softer macro environment. Lower earnings combined with lower P/E multiples = lower asset valuations.
The problem with current equity valuations:
- Earnings estimates are too high for 2023 and 2024. Soft macro demand combined with higher input costs translates to pressured profit margins and earnings. We have seen large layoffs from companies such as Alphabet, Amazon, Meta and Microsoft and more. While those actions provide near-term margin relief they also speak to the larger issue – the unemployment rate is going significantly higher – which will further pull down macro demand (higher prices have already impaired unit growth). Thus, earnings estimates are too high.
- The Fed will overshoot as it relates to tightening monetary policy. This would be bad news for equities as tighter monetary policy means lower asset values. The Fed’s monetary policy of a higher Fed Funds rate combined with QT is a powerful policy cocktail that we have yet to feel the full impact of.
Therefore, what is the appropriate P/E multiple if the Fed takes its Fed Funds Rate north of 5% and settles in around 3-4% long-term? Further, if earnings come in softer than expected over the next 1-2 years that too will compress P/E multiples. The combination of lower-than-expected earnings and lower P/E multiples could knock stocks back another 20-30% over the next year to 18 months.