Is the Equity Selloff Nearing an End…Or Set to Go Further?

Summary

• If analysts’ 2022 earnings projections of 14% growth are right, the S&P 500 selloff is approaching fair value and could be near the bottom.
• Following the retail-related selloff, we estimate the S&P 500 is still overvalued by 3%.
• Analyst projections are good during good times – but they are woefully bad at anticipating recessions.
• If investor fears of stagflation prove well founded, equities face further downside.

Market Implications

• Markets may find a temporary trading range and floor near present levels, but it will surely trend downward if/as analysts revise 2022 earnings projections downward.

Introduction

At this juncture, more than a few investors must be wondering where the bottom might be for equities.

We do not know – we can only say that it depends on various factors, among them Fed policy, the economy, inflation, and whether there is a recession or some major crisis.

What we can do is provide a simple framework for making the most of what we do know.

In our analysis, we have tried to identify the drivers of the S&P 500 over the past 40 years. We have examined a wide range of variables, including earnings, interest rates, fiscal policy, and various economic indicators. We will describe this work in more detail in a subsequent publication. But suffice to say, for now, the one variable that matters far beyond anything else is earnings, and specifically forward earnings.

Analysts Are (Mostly) Good at Projecting Forward Earnings

There is a good reason for this. Look at Chart 1. Forward earnings mostly float above trailing earnings. We could almost say that trailing earnings track forward earnings. This becomes even more apparent in Chart 2, where we compare 12-month trailing earnings with what analysts were projecting 12 months ago. That is, trailing earnings as of December 2001 are matched against projected earnings as of December 2000.

Most of the time, analyst projections are on or near the mark. There is one glaring exception: analysts are terrible at anticipating recessions. Analysts’ projections in 2007 kept calling for rising earnings throughout most of 2008. As Chart 1 makes clear, analysts reined in their projections only as they saw trailing earnings fall off.

Similarly, in early 2019, they had no insight into the coming of the pandemic and so projections into 2020 remained far above reality. Then again, no one saw it coming.

That insight is the basis of our view about where the SPX might be headed in coming weeks or months.

Equities Follow Forward Earnings

Now let us match earnings with the SPX (Chart 3). On the rebased y-axis, we can see trailing and forward earnings move virtually in synch. And, over much of the period, there is a close to one-to-one relationship between earnings growth and the SPX.

The one glaring exception is the past two years, when the SPX raced far ahead of earnings. We can view the selloff in 2022 as equities returning to earnings terra firma.

After the 18 May retail-driven cathartic selloff, the SPX is now overvalued by about 3% – if we buy analysts’ projected earnings growth of 14% for the coming year (Chart 2).

That terra may be less than firma. With the Fed raising rates and investors increasingly worried about stagflation, 14% earnings growth would seem a best-case scenario at this point.

Our best guess is that 2022 earnings projections are headed downward – although if past patterns are any guide, this may not start in earnest until trailing earnings growth slows.

For now, analyst projections are what they are, albeit with a growing uncertainty band. Equities may continue to trade in sharp ranges near present levels but will head lower if/when analysts cut their earnings projections. And the leading indicator for that may be a falloff in trailing earnings growth.

Yes, Other Factors Matter Too

We readily acknowledge this is a simple framework. Many other factors drive equity prices, not the least of which is investor sentiment, which can outrun earnings projections both to the upside and downside. We are just trying to roughly indicate where fair value is amid all the ongoing noise.

Over a 30-year career as a sell side analyst, John covered the structured finance and credit markets before serving as a corporate market strategist. In recent years, he has moved into a global strategist role.