Why is the stock market down?
Interest rate increases are helping to drive down stock valuations
The movements of the stock market can seem mysterious or perfectly rational depending on whether they confirm your own view on economic activity or not. At the most basic level, stocks should do well when the businesses they represent are doing well. So broad stock market performance should be strong when the economy is doing well. However, over the past two years whether or not the economy is doing well seems harder to discern than ever. Covid related shutdowns crippled some businesses while being a boon to others, supply chain issues paired with hot consumer demand have led to barren shelves, easy monetary policy made assets and borrowing appear cheap, tight employment markets made businesses desperate for workers, and inflation has resulted in sticker shock for many common goods. It’s a confusing web of positives and negatives.
As a result, it seems reasonable with this economic backdrop that equity markets have been volatile. Since the beginning of 2020 there have been 264 trading days where the market has been up or down by more than 1%. That is nearly 40% of all trading days in that period, more than twice the rate and the same number of days of +/- 1% trading days than the market experienced in the previous 6 years.
Source: Bloomberg, Ipswich Investment Management
With this unusual price volatility, many may assume that business profits have been similarly erratic, but that is not the case. As the graph to the right depicts, corporate profits did indeed swoon in the quarters directly impacted by COVID lockdowns, however the pullback was short lived and within a few months, sales and earnings were back to previous peeks and soon reached new heights. At this point sales are nearly 18% ahead of pre-pandemic highs while earnings are 32% higher, with expectations for both to advance further into the end of the year. Despite that growth in fundamentals, the market price is only about 9% ahead of the pre-pandemic peak.
So what gives? Fundamentals are better and while a potential recession is being discussed, we have seen no sign of a widespread fundamental weakening in corporate profits yet.
The answer is multiple compression. Investors believe that businesses are worth less today than they were worth at the beginning of year as the perception of general risk is higher. A common valuation method for determining the appropriate price for a stock is the price to earnings multiple of that business. How many times of a company’s profits are investors willing to pay to own the business. A great, dependable or fast growing business usually will trade at a relatively high multiple while a poor or slow growing business will trade at a relatively low multiple. As the chart to the below depicts, the average multiple for the S&P 500 has declined from nearly 32.5x in early 2021 to just 18x. While fundamental growth in business profits account for some of the decline in the market multiple, the majority of the move can be explained by something else.
Source: Bloomberg, Ipswich Investment Management
Interest rate increases are intrinsically tied to stock valuations, as they are the basis for how all financial assets are priced. US Treasury bond yields are often referred to as the “risk-free rate”. While nothing in this world is truly “risk-free”, a bond backed by the full faith and credit of the US government is about as close as we can get. It logically follows that a riskier asset, like a corporate bond, should yield more than a “risk-free” Treasury. Who would own an asset that carries more risk without a commensurately higher yield to compensate for the additional risk? In addition, a stock, which is riskier than a corporate bond, should offer an even higher yield than a bond.
While the stock market valuation multiple mentioned earlier was the price divided by the earnings, that number can be transformed into something more directly comparable to interest rates by dividing the earnings by the price to arrive at an earnings yield. A company doing $5 in earnings per share and trading at a $100 per share has an earnings yield of 5%.
Back when the market was trading at 32.5x in March of 2021, an earnings yield of roughly 3%, Treasury bills were yielding nearly 0% and the 5-year Treasury bond was yielding about 1%. If you assume that a corporate bond would yield at least 1% more than a Treasury with a similar duration, and a stock should yield at least 1% more than a 5 year corporate bond, then about a 3% earnings yield on the market makes some sense.
By the end of September 2022, the 5-year Treasury yield was about 4%. Using the same 1% spread to corporate bonds and 1% more to common stocks, a reasonable earnings yield for the market could be around 6%. That translates into a multiple of about 17x earnings, a bit lower than where we are now.
Inflation concerns brought on by a global economy that roared back to life after COVID shutdowns and oceans of liquidity injected by central banks to avoid the worst pain of the pandemic have resulted in big interest rate increases. These increases slow economic activity by making investment more expensive and making savings relatively more attractive than spending. Taming inflation is important, but the key tool to doing that, interest rate increases, put direct pressure on the value of risk assets.
So, while underlying fundamentals of US companies may be strong and could continue to be solid in 2023 the weight of interest rates will keep a cap on equity valuations broadly. The double whammy could come in the form of increasing interest rates paired with deteriorating fundamental underpinnings. The combination of downward pressure on valuations with weakening fundamentals can lead to more dramatic degradation in asset prices as margins begin to come under pressure. Low multiples on lower earnings would inflict more pain on risk assets like stocks.
This is why we continue to focus on well-run, high quality businesses. These companies are more likely to maintain strong fundamental performance through a downturn and can be in a position of strength to move into new areas, invest in innovation and acquire unique assets when prices are low and prospective returns are high.
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