March 15, 2022
Stocks rallied ahead of tomorrow’s Fed decision. As it stands, we head into a tightening cycle with stocks (S&P 500) down 11% from the record highs (and from the highs of the year).
This decline has reset the valuation on the broad market (lower “P”) — down to a forward P/E of 18.5. That’s above the long-term market average (about 16), but it’s not expensive.
Historically, when rates are low, the P/E tends to run north of 20x. Even if the Fed were to ramp the Fed Funds rate to 2% this year (which would be considered an aggressive scenario), rates are still accommodative (i.e. stimulating growth).
What about the “E” in the P/E?
As we observed in Q4 earnings season, margins are solid – better than the year ago comparison, and better than the five-year trend. Why?
Higher input costs are being passed along to consumers through higher prices. And consumers, while not happy about higher prices, are in a position of strength to maintain their standard of living (with a strong balance sheet and leverage to command higher wages).
For companies, inflation means higher nominal prices, which will result in higher nominal revenue. With that, analysts have been revising UP revenue estimates for Q1. And the expectation is for margins to hold in above 12%, which is above the 5-year average. Add to this, companies are taking advantage of crisis to dial down expectations. This is a formula for earnings beats (yet again) in Q1. And positive earnings surprises are fuel for higher stock prices.
So, we may find that the behavior of investors over the past two months has followed a long-standing investing maxim: “selling the rumor, buying the fact.” In this case, “selling the anticipation of the first Fed rate hike … and buying on the actual event.”