The Math Just Doesn’t Work For US Stocks

It’s still not a real selloff.

US equities suffered their second worst week of a very bad year thanks to an inflation report which suggested price pressures broadened further last month and are now embedded across the economy.

And yet, the ongoing malaise is just that: Dull drudgery. It’s too orderly to constitute any kind of bottom. And the world’s risk asset benchmark par excellence still hasn’t succumbed convincingly to the bear (figure below).

As discussed here earlier this week, that drawdown scarcely counts as notable historically, and when juxtaposed with what it’s fair to call one of the most fraught macro backdrops in modern history, it feels woefully insufficient.

“Despite the 18% YTD decline, equity valuations remain far from depressed,” Goldman’s David Kostin said. Consider that the median S&P stock still trades on an 18 multiple, in the 87th%ile since 1976.

The figure (below) underscores the point. There may indeed be bargains aplenty but the index isn’t one of them — not on an absolute basis and not on a relative basis either.

“Valuations appear more attractive in the context of interest rates, but still do not look ‘cheap,'” Kostin went on to say, noting that the 540bps gap between the median stock’s earnings yield and 10-year US reals is middling. Note that IG yields are on the brink of eclipsing the S&P’s payout rate. That hasn’t happened since 2009.

The more challenging the economic backdrop, the harder this is to justify. Goldman expects valuations to stay flat for the remainder of 2022, leaving earnings growth to pull the S&P back up to 4,300 by year-end. But to say it’s difficult to conjure a coherent narrative would be to materially understate the case.

“Inflation surprises will… affect the path of multiples, for better or worse,” Kostin remarked, before noting that “some of the economic developments that have boded well for the Fed’s battle with inflation have intensified concerns about the earnings outlook.”

He mentioned indications from a few tech companies that hiring may slow, which is a positive development for helping to balance the labor market, but “reflects management anxiety about growth and inflation.” It’s a lose-lose environment.

If inflation remains elevated, that’ll crimp margins on at least two fronts: Input costs and wage pressures. At the same time, the read-through for monetary policy from CPI reports like the one markets struggled to digest on Friday is for aggressive tightening. That’ll hold back valuations. So: Constrained profitability and constrained multiples.

“Stagflation [is] incompatible with the ‘Goldilocks’ P/Es of 20x over the past 20 years,” BofA said, reiterating that multiples “should be closer to the 20th century P/E of 15x.”

For their part, Goldman doesn’t think the inventory overhang will be as vexing for most companies as it appears to be for some of America’s largest retailers, but Kostin conceded that “slowing growth and still-elevated input costs will pressure margins and revenues.”

When you throw in the FX headwind (Microsoft won’t be the last multinational to guide lower on a stronger dollar), you’re left to ponder a very challenging calculus. The figure (below) shows just how challenging.

Goldman’s top-down, base case for 2023 EPS is $239. Consensus bottom-up is at $251. The table assumes that by year-end, consensus 2023 EPS forecasts move halfway towards the various scenarios mentioned at the top.

So, if the consensus 2023 EPS estimate moves halfway to Goldman’s top-down forecast and multiples stay at current levels, the S&P would trade around 4,150. If, by contrast, consensus moves halfway to a recession scenario, and multiples contract to 14x, you’re left with the S&P at 3,150.

It’s easy to get lost in the math, so let me clarify something. The $225 figure Goldman uses under “median recession” assumes consensus moves halfway to the median, post-War, LTM S&P earnings decline during recessions (figure one the left, below).

Trough earnings declines can be very large

But a more granular look at profits during recessions shows the median trough, on a quarterly, YoY basis, was a decline of more than 20% (figure on the right, above).

The point isn’t to goal seek the worst possible outcome. Rather, I just want to emphasize that no recession is exactly alike, and there’s a good argument to be made that the next recession, assuming it’s catalyzed by a combination of Fed hikes, consumer retrenchment in the face of generationally high inflation and gale-force margin headwinds, will be uniquely, if not singularly, painful.

You can do the math for yourself. 2021 S&P EPS was $209. It’s not terribly difficult to get to an index level below 3,000. There are any number of plausible permutations that suggest US equities could easily shed another 25% under what might count as a benign scenario considering the macro and policy circumstances. And that’s to say nothing of the distinct possibility that the Fed is actually angling to push stocks below pre-pandemic levels in order to kneecap inflation by bleeding the wealth effect.

Forgetting all of that, and sticking with Goldman’s scenario analysis (as shown above), note that only a handful of permutations result in meaningful upside for US equities. Just two of them result in appreciable upside.

Again: The math for a bull case is very challenging from here. I’d go so far as to suggest it flat out doesn’t work.

Paradoxically, the best outcome for stocks might be a surprise 75bps (or even 100bps) hike from the Fed. That could send a message about the Committee’s conviction vis-à-vis the inflation fight. But even that could end up being circular and self-defeating. After all, equity gains are anathema to that very same fight.