This year, the stock market experienced its worst first half in 50 years. The S&P 500, the main benchmark for US equities, fell 24% and the tech-heavy Nasdaq lost 33% of its value.
However, the fall in prices had little to do with corporate finances. (For example, when the S&P 500 collapsed in the first quarter of 2020, earnings grew 4.4% from a year ago). Instead, it was a result of a market phenomenon called “multiple compression.”
In plain language, it is a reduction in the price investors are willing to pay for a dollar in a company’s profits.
According to JPMorgan’s calculations, the first half of 2020 saw the most ferocious compression in the past 30 years — beating the dotcom crash and the aftermath of the 2008 housing market collapse.
“The S&P 500 has seen its second sharpest P/E rating in the past 30 years, surpassing the typical compression seen in previous recessions. While the current stock multiple is in line with the historical median, we believe it is better than fair value…” JPMorgan wrote in an internal note.
The big picture
If it’s not a profit, then why are investors hesitant about how much they’re willing to pay for stocks?
Two things: 1) the Fed’s struggle with inflation and the conflict between Russia and Ukraine.
Since the beginning of this year, the Fed has implemented its most aggressive rate hikes in decades to contain near-double-digit inflation. Such an aggressive Fed does not bode well for risky assets, as higher rates increase the cost of borrowing and lower valuations.
Meanwhile, the West’s confrontation with Russia over Ukraine is throwing a rift in global energy and food supply chains, while fueling the very inflation that central banks are trying to eradicate.
The good news is that the doom and gloom, priced into the downturned valuations, may already be behind us.
At the latest FOMC meeting, Powell gave a calm undertone, pointing to a slowdown in rate hikes. Meanwhile, inflation is showing signs of peaking, all of which could lead to what JPMorgan calls “a reset of investor expectations.”
“Whether it’s earnings or the Fed, we’re seeing a reset in investor expectations: Last week’s more subdued Fed meeting, which saw key rate hikes near neutral, along with declining inflation expectations and falling bond yields, indicates that the peak of hawkishness probably lags behind. Risk markets are recovering despite some disappointing data releases, indicating bad news had already been anticipated/priced in,” JPMorgan analysts wrote in an internal note.
In fact, according to JPMorgan’s internal survey, 58% of its institutional clients plan to increase equity exposure.
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