Two factors that determine the direction of stock prices are 1) expectations of earnings increasing or decreasing, and 2) the market multiple (price/earnings ratio), which is an estimate on what investors are willing to pay for a future stream of earnings. 

Both are under pressure.

“Long-term interest rates are rising, so that will lower the acceptable P/E ratio (and cause ‘multiple contraction’),” Matt Maley from Miller Tabak said in a note to clients this weekend.

These multiples have begun to reverse after a 12-year period where they slowly expanded, in some cases dramatically.

Multiples (P/E ratios) traditionally go up during periods of economic expansion, since investors try to front-run higher future earnings and thus bid up stock prices. 

But the multiple can also expand during periods of easy money, when investors have plenty of cheap money they can invest and are willing to use leverage as well.

The period after the Great Financial Crisis has not only seen cheap money, it has seen a dramatic expansion of the Fed’s balance sheet, now at close to $9 trillion.  

It is not unreasonable to assume that a good chunk of that money has found its way into the stock market.

Some evidence can be found just looking at the multiple of the S&P 500.  The S&P is now trading at 19.6 times 2022 estimates.  Historically, it has traded in the 15 to 17 range, but after the Fed began pumping huge amounts of money into the economy in 2009 the multiple slowly expanded, to almost 22 by the early part of 2018, then expanded again after the Fed pumped even more money into the economy following the Covid pandemic.  It’s been coming down since that peak.

You can also look at the abnormal market returns.

Every market historian has taken note of the extraordinary run stocks have experienced in the last decade. Since 2009, the S&P 500 has averaged gains of roughly 15% a year, well above the historic returns of roughly 10% a year.

Many traders attribute that 5 percentage point yearly outperformance all or partly to the Fed.

If that is the case — and all or a good part of that excess gain is due to the Fed — than it is reasonable to expect that the Fed withdrawing liquidity and raising rates might account for a future period of sub-normal (below 10%) returns.

The prospects of a lower multiple due to higher rates is one problem, but when you combine that with a less rosy business outlook the results can be very dramatic.

Netflix is a good example of extreme multiple compression: It is now trading for the same price ($397) it traded at in the second quarter of 2020, yet the multiple — the value an investor is willing to put on a future stream of earnings — is much lower today.  It is now trading for 34 times 2022 estimates; in 2020, it was trading at 88 times 2020 earnings.  Two years prior, the multiple was even higher: 174 times 2018 earnings, according to Factset.

Why has the multiple dropped so suddenly?  Investors are not willing to pay as much for that future stream of earnings as they were two years ago.

In the case of Netflix, the business environment is becoming more challenging, so there is good reason for investors to be cautious.  However, many companies still face good business climates but multiples have been dramatically cut as well.

While the multiple on the S&P 500 contracted slightly by the end of 2021, it was an enormous rebound in earnings (up 47% for the full year) that powered the S&P’s 27% gain last year.

But expectations for 2022 are far less elevated: a gain of roughly 8%.

That is much closer to the historic earnings growth range of roughly 6%.

With multiples contracting, and earnings growth much more modest, many strategists are understandably concerned that the market is vulnerable.

“Earnings momentum has slowed and we see risks to 2022 EPS amid continued inflationary pressure,” Savita Subramanian from Bank of America said in a recent note to clients.

“We expect P/E contraction to more than offset EPS growth this year,” she said.

If you’re expecting that 2022 will see the enormous earnings bump the S&P saw in 2021, you’re going to be disappointed.

First, companies are reporting more “normal” earnings beats.   In 2021, it was not unusual to see companies reporting earnings 20% above what analysts were expecting.

That is not happening anymore.

Of the roughly 60 companies that have reported so far, 76% are beating estimates, according to The Earnings Scout. That is high but well below the 88% beat rates from the prior quarter.  More importantly, they are beating by only 7.4%, well below the 15% beat rates those companies reported last quarter.

This is much closer to the “normal” historic range, where companies in the S&P would typically beat by 4%-6%.

Another factor fueling the market’s growth last year: constant and aggressive increases to future earnings estimates.  

That, too, has slowed dramatically.

First quarter earnings estimates for the S&P 500 have declined from 7.5% growth on January 1 to 7.0% today.  While that may seem small, earnings estimates had been rising through all of 2021.

“Actual earnings growth is decelerating and will last at least two more quarters,” Nick Raich from The Earnings Scout said in a note to clients last week. “Furthermore, our research indicates Fed interest rate hikes are not baked into 2H of 2022 EPS estimates yet either.”

The pressure on market multiples and earnings is likely to continue. 

One particular pressure point for earnings is profit margins, which is simply the amount of profit corporations get to keep after paying costs.  Rising labor and raw material costs are now likely to last into the second half of the year.

Railroad giant CSX, paint manufacturer Sherwin-Williams, coatings maker PPG, and water treatment giant Ecolab all reported significantly higher costs in their earnings reports.  Some, like CSX, saw higher costs due to fuel and labor costs, but were able to offset those costs with price increases.  Others have had more difficulty raising prices.

How far could the S&P drop?  It depends on what your view on the economy, on corporate America’s ability to continue to raise prices in the face of higher costs, and on interest rates.

Maley notes that while rates are still low on an historic basis, the yield on the 10yr note was still below 1.5% in both 2012 and 2016, a time when the S&P was far more reasonably priced, trading at 13x earnings in 2012 and just above 17x in 2016.

“If today’s stock market was going to fall into the middle of that range (assuming the earnings estimates don’t fall like they usually do), the S&P is going to have to fall well below 3,500,” Maley said.