Fed’s Stern Message Amplifies Worries About Stock Valuations

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The trajectory of inflation and interest rate hike has sparked a debate on market valuations in the current environment.

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Stocks were narrowly mixed on Tuesday, with the Dow Jones Industrial Average down 152 points, or 0.5%, and the Nasdaq Composite Index up 0.2%. The Nasdaq and S&P 500 are in a bear market, defined as a decline of at least 20% from their highs.

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Many investors argue that the worst in the markets could be over soon, given the extended declines in several market segments this year and the generally healthy state of the US economy. He says buying dips have fallen out of favor during this year’s downtrend, but this negative sentiment is often a harbinger of an extended rebound.

But many optimists in the stock market also believe that a rebound will be faced with some significant hurdles, first and foremost high valuations, which are one of the strongest factors for predicting market performance over time. Even with the S&P 500 down 22 per cent in 2022, many investors and analysts fear the stock market’s valuation will fall further. According to FactSet, the S&P 500 on Monday traded at 15.8 times its expected earnings over the next 12 months, which is still above the 15-year average of 15.7.

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In periods of crisis, investors can quickly decide that the shares are too low to be worth. And historically, valuations have fallen before the bottom. In the December 2018 sell-off, the S&P 500’s forward multiple fell to a low of 13.8 during the Fed’s most recent previous rate-hike cycle. In the depths of the March 2020 sell-off, as the economy swelled due to the advent of the Covid-19 pandemic, the index traded as low as 13.4 times its estimated earnings.

“The market is usually not down near historical arbitrage,” said Greg Svensson, portfolio manager at Leuthold Group. “They monitor the downside from a valuation perspective.”

Adding to the concern: Many investors have begun to worry that corporate profits are under threat, suggesting that valuation measures based on earnings estimates can give an idea of ​​how expensive stocks really are. US companies have warned of challenges on several fronts, from rising costs to a fall in forex due to a stronger dollar.

“Those valuation multipliers are actually based on an overly optimistic earnings outlook,” said Mr. Swenson.

Another valuation model, the Buffett indicator, compares the value of publicly traded companies in the US to the nation’s gross national product. As of late last week, a version of that measure was 29% above its historical average and well above its peak in the dot-com bubble days of 2000, indicating that the market is overvalued. The metric was named after Warren Buffett, who once called the indicator “probably the best single measure”. [stock market] Evaluation stands at any time. ,

The Fed’s campaign to tame inflation is adding to the dynamics that have ruled the stock market in recent years, when rock-bottom interest rates prompted investors to seek returns in riskier assets. The popular idea that the stock had no options helped propel the S&P 500 ever higher, reaching a recent valuation peak of 24.1 times its estimated earnings in September 2020.

Recently, concerns about inflation and the way interest rates will rise have provoked turmoil in the markets as well as vigorous debate over the correct valuation of stocks in the current environment. One source of concern is the risk that the Fed’s tightening will push the economy into recession, hurting both business fundamentals and investor sentiment. More immediately, higher interest rates often reduce the value of companies’ future cash flows in the pricing model used.

One concern for financial markets is that bond investors are beginning to anticipate not only a faster path to growth, but a higher destination or so-called terminal rate for the Fed. On Tuesday, investors in interest rate futures markets put an almost 89% chance that the Fed will raise rates to around 4% or more by June 2023. According to CME Group, the market-implied probability was 1% four weeks ago.

Raising rates by a 0.75-percentage-point, or 75-basis-point, this week could be a way to capture a rise in inflation that has been much higher and more persistent than officials had predicted. Evidence that measures of inflation expectations are rising by businesses and households over a long period of time, especially inside the central bank, would be alarming.

Two recent surveys have indicated that consumers’ long-term inflation expectations are rising. Fed officials have said they would like to react aggressively to signs that such expectations are rising, or “de-anchored”, because they believe that if that happened, inflation could be driven down by the economy. The process would be much more difficult.

“My understanding is that the Fed decided to do 75 basis points instead of 50 basis points because of the data we’ve got over the past week or so showing higher inflation and maybe some more troubling news on inflation expectations. ,” said former New York Fed Chairman William Dudley at the Wall Street Journal CFO Network event on Tuesday.

Mr Dudley said the same arguments for a 0.75-percent-point rate increase could be used to make the case for a one-percentage-point increase “because if you decide the speed to get there is just as important As for the level you’re about to reach, why not get there faster?”

But he said he expected officials were “probably splitting the difference” instead of a 0.75-percent-point move.

Analysts who closely analyze the central bank’s policies were divided on Tuesday on whether potential costs could lead to a shift from the half-point rate hike expected before the most recent inflation report to a more aggressive 0.75-cent-point rate hike. have taken more advantage than any profit from.

Some warned that the central bank risked creating more confusion in financial markets by recently providing an unusually accurate steer that it would raise rates by half a percentage point this week. Krishna Guha, vice chairman of Evercore ISI, said in a note to clients on Tuesday that he is concerned that the 0.75-point rate hike “is not inherent in a credible and systematic policy strategy and, without it, risks looking like a dire response.” …he may not be aged well.”

Mr Guha, a former New York Fed adviser, said such a move created “serious morning-after problems” by inviting difficult-to-answer questions about what the Fed would do next.

Economists at Deutsche Bank said they expect the Fed to raise rates again to 0.75 at its July policy meeting, far above levels designed to actively slow the economy by the end of this year. Closer will keep on track to raise rates. ,

“Those moves are more consistent with … our own view that a restrictive policy stance is necessary to contain inflation,” wrote Matthew Luzzetti, chief US economist at Deutsche Bank. “Such a move would also help build the Fed’s credibility that the monetary-policy stance is adjusting quickly to a new reality of ever-increasing inflation.”

Write to Karen Langley at [email protected] and Nick Timiraos at [email protected]

Credit: www.Businesshala.com /

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