Mark Congdon, Founder & President
On my June 1st conference call with clients, I broke down the current slide in the markets. I explained that ultimately the revaluation of stock prices would be the result of a reset to both sides of Price/Earnings (P/E) ratios. The first (and most painful) adjustment we are experiencing is to price. Price is expressed as the multiple of earnings investors are willing to pay for stocks. This time last year, the S&P 500 was priced at 37 times trailing company earnings. At the time of my call on June 1st, the P/E ratio of the S&P 500 had dropped to 21 times trailing earnings. The primary reason for this drop was a substantial rise in interest rates, which the Federal Reserve had telegraphed ad nauseum. Higher interest rates make stocks less valuable because future earnings are discounted by current interest rates. Since markets had already factored in three half-point increases from the Fed (before any actually occurred), I dared to suggest we may be towards the end of this relatively severe mathematical “price” adjustment.
Then came the hotter-than-expected inflation numbers last week. Stock and bond markets started tanking Thursday when the White House pre-emptively suggested the numbers may be worse than expected. Fridays release of the data showed red hot inflation, demonstrating clearly that the Fed was behind the eight ball. Interest rates spiked in the open market with the possibility the Fed will raise rates higher and more often than previously announced to combat inflation. The reaction in the equity markets was swift and severe with the S&P 500 dropping 9.6% and the Nasdaq shedding 10.6% over the last three sessions. P/E ratios have dropped yet again. The table below clearly demonstrates this relationship between interest rates and P/E ratios:
|June 13, 2021||June 13, 2022|
|2-Year Treasury Note||0.16%||3.38%|
|10-Year Treasury Bond||1.50%||3.35%|
|S&P 500 Price/Earnings Ratio||37x||19x|
Once again, I’ll suggest we’re closer to the end of the price adjustment that has shaved 22% from the S&P 500 and cut the Nasdaq by a third from all-time highs. Where the market heads from here will depend on the adjustment to corporate earnings over the coming quarters. It remains to be seen how higher rates and inflation will affect consumer behavior, and ultimately corporate profits. Some industries, like energy and basic materials, are profiting from a surge in pricing power. Others, like homebuilding, are being crushed as mortgage rates have spiked to 6.13% for a 30-year fixed mortgage. In the coming months, the market will tally the results and move accordingly. This explains the high stakes facing the Federal Reserve as they attempt to curb inflation without damaging the economy.
Having a long-term investment strategy implemented with a broadly diversified portfolio of equities, bonds, and cash is imperative in times like these. This is especially true if you are living off your investments. It’s even more important that you understand - and are so comfortable with your strategy - that you can sleep well regardless of what scrolls across the CNBC ticker at the end of the day. As always, we’re here should you want to talk.
P/E ratios referenced in this article were provided by the Wall Street Journal (https://www.wsj.com/market-data/stocks/peyields). Treasury Yields referenced were provided by MarketWatch (www.marketwatch.com) . The opinions expressed and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security.