Posted by lplresearch
Stocks are only down about 6.5% from record highs in January based on the S&P 500 Index. While hardly cause for celebration, in the face of war in Ukraine, surging inflation, and tighter monetary policy by the Federal Reserve, it’s fair to say stocks have been resilient in the face of those challenges. So why haven’t stocks fared worse? Well, there are two ways stocks can rise, either more earnings or higher valuations. This year has been all about earnings and we must look no further than interest rates to see why.
Higher interest rates tend to correspond to lower valuations, as shown in the LPL Research Chart of the Day which plots sixty years of data comparing the S&P 500’s price-to-earnings ratio relative to 10-year Treasury yields. Year to date, the S&P 500 Index price-to-earnings ratio based on consensus earnings estimates for the next 12 months has fallen from 22 to 19 as the 10-year U.S. Treasury yield has risen by about 80 basis points (0.8%). Meanwhile, the consensus estimate for S&P 500 earnings per share has risen by about 2% to over $227 per share, above our current $220 estimate.
“Clearly the market hasn’t forgotten about the relationship between interest rates and stock valuations,” explained LPL Financial Equity Strategist Jeffrey Buchbinder. “With rates higher, not to mention more inflation, the path for the S&P 500 to return to prior high valuations is getting tougher.”
Looking ahead, we see opportunities for stocks to break out to new highs later this year on a combination of earnings gains and some recovery in valuations. But inflation is going to be a key determinant on both fronts. Corporate America must continue to manage cost pressures effectively while markets must see light at the end of the inflation tunnel.
On earnings, besides inflation, companies are dealing with slower economic growth, particularly in Europe, and COVID-19-related supply chain disruptions that are far from over. At the same time, Wall Street’s earnings estimates continue to hold up well and companies are generally enjoying pricing power.
Bottom line, we anticipate a combination of some recovery in valuations and solid mid-to-high single digit earnings gains from corporate America will get stocks back to record highs over the next quarter or two. That optimism rests on our belief that interest rates will soon stabilize and inflation will soon peak. But no doubt the path forward for stocks has gotten tougher.
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All index and market data from FactSet and MarketWatch.
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