I’ve spent quite a bit of time opining on both the re-rating in US equities that played out over the first five weeks of 2023 and the risk to earnings estimates going forward.
The issue with the early-year multiple expansion was that it outpaced what could be justified by the concurrent decline in real US yields.
The forward multiple tends to exhibit an inverse relationship with real rates (for obvious reasons), and although 10-year reals did recede materially from early January through February 3 (when the hot US jobs report changed the game), it wasn’t obvious that the decline warranted the scope of the concurrent re-rating.
The simple figure above makes the point. The S&P re-rated back out to 18x (it actually went higher than that) and the Nasdaq 100 to 24x, neither of which were consistent with the comparatively modest drop in reals.
You could also argue that stocks never entirely caught down to real rates in the first place. Assuming that’s an accurate characterization (remember, we’re just eyeballing a chart here, not running any kind of statistical analysis), it’s even more problematic now because in the wake of February’s hawkish repricing across the US rates complex, reals are higher than they were to start the year.
“[The] resumption of higher rates [is] creating a multiple contraction / valuation headwind, offsetting the tailwind from better-than-expected global growth, feeding [a] ‘running to stand still’ chop dynamic in stocks of late,” Nomura’s Charlie McElligott said.
One crucial point to grasp in all of this is that even in the face of a difficult rates environment, multiple expansion might make a measure of sense if earnings were expected to inflect for the better at some point in the relatively near future.
I’ve said this again and again: The market doesn’t generally put a trough multiple on trough EPS, so if you’re bullish, you could argue equities are being “efficiently forward-looking” as opposed to “excessively starry-eyed.”
The problem is that profit estimates for this year have come down fairly dramatically, and I think it’s fair to say that by and large, management hasn’t yet thrown in the proverbial towel. So, the question is this: If company analysts have, mostly of their own volition, cut estimates by ~10%, what’s the situation going to be in the event bears are right to suggest that margin forecasts are still far too rosy?
You might say that because bottom-up consensus is now in the same ballpark with some top-down strategists (who were relatively bearish versus company analysts last year), much of the risk is now in the forecasts. But, again, there are lingering concerns about margins and not every top-down strategist thinks $224 is a safe guess for aggregate profits this year.
Ultimately, the concern is that scarcely anyone is being especially realistic (let alone cautious) about the outlook for earnings even after all the cuts represented by the second visual above.
When you pull in the rates discussion, the situation is more vexing still. It’s possible that the market is assuming a multiple consistent with a macro regime that ceased to exist in the 2020s, and is assigning that multiple to an unrealistically high estimate of index-level profits.
If that’s right, then there’s a long way down, because it suggests investors are paying too much for every dollar of assumed earnings and also that some of those assumed dollars aren’t likely to materialize.
