THIS IS WHY THE STOCK MARKET WILL HAVE A HARD TIME GOING UP IN 2022

08 February 2022





THIS IS WHY THE STOCK MARKET WILL HAVE A HARD TIME GOING UP IN 2022




By Raul Elizalde

This article also appeared on forbes.com


The stock market has been very generous in the past 13 years. The S&P 500 is six times higher than the financial crisis low of 2009 and every decline since proved to be an opportunity to buy. But the market generosity may have reached its limits. Historically speaking, U.S. stocks as an asset class are as expensive as they have ever been. While this could persist, the chances of a double-digit return this year are slim.

source: Path Financial LLC, Prof. Robert Shiller (Yale U.)
The stock market has been very generous in the past 13 years. The S&P 500 is six times higher than the financial crisis low of 2009 and every decline since proved to be an opportunity to buy. But the market generosity may have reached its limits. Historically speaking, U.S. stocks as an asset class are as expensive as they have ever been. While this could persist, the chances of a double-digit return this year are slim.

source: Path Financial LLC, Prof. Robert Shiller (Yale U.)
To be clear from the start, the charts in this article forecast nothing at all. It would be wrong to conclude that a major reversal is around the corner just from these charts, and long-timers like me have learned the hard way that “the market can stay irrational far longer than you can remain solvent.” That is to say, just because the market is historically high today won’t prevent it to become even higher in the months ahead.


What the charts clearly show, however, is that stocks are very expensive. And if one were to look for a reason why the next likely direction is not upwards, it would be that the regime that supported increasingly expensive stocks is no longer in place.


For the better part of the last 12 years monetary policy was loose, as the Federal Reserve kept the economy awash with money and interest rates low. I will not discuss the merits or mistakes of such policy here, but I will note that one consequence of this policy was to make the price of financial assets soar.


Interest rates around historical lows were a boon for equities, simply because when stocks are priced according to the present value of future dividends, lower rates make those future dividends more valuable today. But even stocks that don’t pay dividends benefited from those loose policies.


Fiscal policy joined monetary policy in stimulating not just the economy but financial markets. This probably started with the massive corporate tax cut of 2017 that put a lot of money into public companies’ pockets, a significant portion of which was used to buy back stocks and increase dividends. This was followed by a mountain of stimulus money intended to shore up a pandemic-stricken economy, but that money also found its way into financial assets, in great part because of its poorly planned, inefficient distribution. This monetary-fiscal stimulus kept the market rising for years.


All this came to an end when inflation surged, which forced the Fed to reverse policy. The Fed is now ratcheting back money injections, which will soon stop altogether and will be followed by interest rate hikes. Whether the change in policy will do more harm than good is a topic I explored in a recent post. Either way, tighter monetary policy is now the lay of the land, and it represents a fundamental departure from the conditions that supported the stock market in recent years.


Future dividends are worth less when interest rates go up. Higher rates on bonds make them more attractive against equities. Less money in the system means fewer flows into financial assets in general. All this may impact stocks not just directly but by virtue of depressing investor sentiment.


Sentiment, along with liquidity and rates, is an important factor affecting “multiples” which are ratios that determine the value of stocks. The best known is the Price-Earnings (PE) ratio, or the ratio between the price of a stock and the previous 12 months of earnings. A company like Disney has a PE ratio of 130 – that is, the value of Disney’s market capitalization is 130 times its corporate earnings. Meanwhile, Citigroup’s number is 6. The PE ratio can also be calculated on projected future earnings, rather than past earnings. This is the forward PE ratio, which in the case of Disney is 35 and Citigroup’s is 9.


What is the proper PE ratio? Each sector has its own and within each sector PE ratios fall within a very wide range. The proper PE ratio, therefore, is just what the market thinks it should be. In other words, it depends on sentiment.


An aggregate PE ratio for all stocks in the S&P 500 can be computed as described above, but Prof. Robert Shiller of Yale (who received the Nobel Prize in Economics) prefers to calculate it using the 10-year average of past earnings. The idea is to span different business cycles and make the number more useful.

source: Path Financial LLC, Prof. Robert Shiller (Yale U.)
Even on that basis, the PE of the S&P 500 has not settled on a stable value. It ranged from a low of 7 in 1981 to a peak of 44 during the dot-come boom. The ratio today is not far from those historical peaks. When averaged using 5 years of earnings instead of 10 the ratio is even closer to the all-time peak.


There is little doubt that, historically speaking, anyone making the case that stocks have significant upside from here is really saying that they will have to become even more expensive on a historical basis. Some insist that stocks will be fueled by earnings, which they expect to grow. The problem is that unless earnings go through the roof, the current consensus for earnings growth is not enough to push stocks higher.

source: Path Financial LLC, S&P Dow Jones Indices
The current consensus on earnings growth, as tracked by S&P Dow Jones Indices, is that they will settle around 8%-9% annually within the next couple of years (the average since 1990). Using this number along with an unchanged dividend policy, a gradual decline of inflation towards 4% by year end and, crucially, the same PE ratio as today, the S&P 500 level at the end of 2022 comes out around 1% below the close of 2021. The direction of stocks in the next few quarters, therefore, depends entirely on the PE ratio. A relatively modest decline will push the S&P 500 below today’s level.


This is a tough proposition, because the PE ratio depends in turn on the investors’ mood which is exceedingly difficult to predict. The fact that the PE is historically very high offers little confidence that it could stay at these heights by the end of the year, especially as monetary policy has changed and this tends to sour sentiment.


It’s worth insisting that the future is unknowable. The only statement that comes close to a guarantee is that, regardless of the general market direction, some individual stocks will do great. The problem is that when the general market faces headwinds, the risk of making the wrong choice goes up. As the market becomes less generous, investors need to be more careful about what they include in their portfolios.


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