Transcript:

Amanda Agati:

In this edition of "Adding Alpha," we take a look at the inverse relationship between interest rates and equity valuations to get a sense of how much more multiple compression might lie ahead for equity markets. 

Spoiler alert -- we think most of the recalibration has already occurred.

It's the worst start to a year for stocks since 1970, and perhaps it's not entirely surprising considering the perfect storm of macro headwinds that continue to swirl.

But even in the face of all of this, we haven't yet seen a decline in earnings estimates.

The downdraft in markets this year has so far been largely a function of multiple compression, driven by the "P," or the price in a P/E ratio, coming down, while the "E," or the earnings estimate, is, believe it or not, still holding pretty steady.

We're down about 5 multiple points on the S&P 500 since the beginning of the year, to about 16.5 times, which is effectively back to 2019 valuation levels.

We're down 6 multiple points from the market's peak in 2021.

For comparison, when the Fed went on autopilot with quantitative tightening all the way back in 2018, we lost about 5 multiple points over the course of that year.

This time around, it's happened in just four months.

From the record-breaking market collapse at the onset of the pandemic to the record-breaking rally that ensued and back into correction territory for both stocks and bonds this year, everything this cycle is happening at warp speed, including the recalibration of interest rates and monetary policy and, of course, valuations.

We know over time there tends to be a pretty strong inverse correlation between interest rates and equity valuations.

With the 10-year Treasury yield doubling just since the beginning of the year, is it any wonder we've seen multiples compress so rapidly?

We took a look at trailing and forward P/E's for the S&P 500 relative to the 10-year yield using data going all the way back to 1954.

And based on the math, with the 10-year trading at about at 2.9% as of this recording, the trailing P/E on the S&P 500 should be priced at about 20.15 times.

Amazingly, we're actually sitting right on that figure at 20.14.

When we look at things from a forward P/E basis, the math actually works out to a projected 15.8 times, versus the roughly 16.5 times we're trading at now.

So we're really, really close on this metric, too.

From our perspective, this suggests that we are indeed effectively priced at fair value relative to where the 10-year Treasury is yielding today.

We've had this major recalibration in valuations, we've seen multiple compression, but it's really a function of the Fed tightening financial conditions.​

Even though the Fed clearly still has some more work to do, the market is already pricing those moves in.

And so we think the worst of it may actually be behind us now from a financial conditions tightening perspective.

Earnings estimates for 2022 and 2023 still point to pretty solid fundamentals overall.

We're looking at about 10% earnings growth for each of those years.

But with the VIX still hovering around 30, which is about two times the long-run average for the equity market, we're definitely not out of the woods yet as it relates to this high-volatility, choppy regime.

But a stabilization in the interest rate backdrop and financial conditions could be just enough for the market to finally begin to refocus its attention on the still-solid underlying fundamentals and chart a path higher in the second half of the year.