Fed’s harsh message amplifies concerns about equity valuations

The prospect of faster-than-expected monetary tightening rocked Wall Street, dragging the S&P 500 deeper into bearish territory on Tuesday and forcing investors to reassess a stock market that doesn’t look cheap even after its massive sell-off.

It’s been a rough patch for markets, reflecting concerns about the resilience of the economy as the Federal Reserve embarks on its biggest interest rate hike in decades. Investors expect a 0.75 percentage point rise on Wednesday, which would be the biggest since 1994.

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

Many investors say the worst of the markets may soon be over, given the prolonged declines in many market sectors this year and the generally healthy state of the US economy. They say buying the dip fell out of favor during this year’s rout, but negative sentiment is often a precursor to an extended rally.

But even many stock market optimists admit that a rebound would face significant hurdles, first and foremost high valuations, which over time tends to be one of the most powerful predictors. market performance. Even with the S&P 500 down 22% in 2022, many investors and analysts worry that stock market valuations will continue to fall. The S&P 500 traded Monday at 15.8 times its projected earnings over the next 12 months, according to FactSet, still above the 15-year average of 15.7.

A rate hike on Wednesday by a bigger jump of 0.75 percentage points, or 75 basis points, could be a way for the Fed to catch up to a rise in inflation that has been much higher and more persistent than authorities had not anticipated. Evidence that measures of long-term corporate and household inflation expectations are rising would be particularly alarming within the central bank.

“My feeling is that the Fed decided to go 75 basis points rather than 50 basis points because of the data we got over the last week or so showing higher inflation and perhaps more worrisome news on inflation expectations,” former New York Fed Chairman William Dudley said at The Wall Street Journal CFO Network event on Tuesday.

Mr Dudley said the same arguments for a 0.75 percentage point rate hike could be used to argue for a one percentage point hike “because if you decide that the speed Getting there is just as important as the level you’ll reach, so why not get there faster? »

But he said he expected officials to “probably split the difference” by opting for the 0.75 percentage point move instead.

Analysts who closely analyze central bank policies were split Tuesday on whether the potential costs outweighed the benefits of moving to a more aggressive rate hike of 0.75 percentage points from the half-point rate hike expected ahead of recent inflation reports.

The Dow Jones Industrial Average fell 0.5% on Tuesday while the Nasdaq Composite rose 0.2%. Some fear that Fed tightening could push the economy into a recession.


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Some have warned that the central bank, by recently providing unusually sharp guidance that it will raise rates by half a percentage point this week, risks causing further confusion in financial markets. Krishna Guha, vice president of Evercore ISI, in a note to clients on Tuesday, said he was concerned that the 0.75 point rate hike “would not be embedded in a credible and systematic policy strategy and, without it , may sound like a panic response…it may not age well.

Mr Guha, a former New York Fed adviser, said such a move created a “serious tomorrow problem” by inviting tough questions to be answered about what the Fed would do next.

The Fed’s campaign to control inflation is upending the momentum that prevailed in the stock market in recent years, when rock-bottom interest rates pushed investors to seek returns in risky assets. The popular view that there was no alternative to equities helped push the S&P 500 ever higher, reaching a recent valuation peak in September 2020 of 24.1 times its projected earnings.

More recently, concerns about inflation and the path of interest rate hikes have caused market turmoil and heated debate about the right valuations for equities in the current environment. One source of concern is the risk that Fed tightening could push the economy into a recession, hurting both business fundamentals and investor confidence. More immediately, higher interest rates reduce the value of future business cash flows in frequently used pricing models.

One of the concerns in financial markets is that bond investors are beginning to anticipate not only a steeper upside trajectory, but also a higher destination or so-called terminal rate for the Fed. On Tuesday, investors in the interest rate futures markets estimated nearly an 89% chance that the Fed would raise rates to around 4% or more by June 2023. That implied market probability was 1% four weeks ago, according to CME Group.

In times of distress, investors may be quick to decide that stocks are worth much less. And historically, valuations have fallen further before hitting bottom. In the December 2018 sell-off, during the last Fed rate-hike cycle, the S&P 500 futures multiple fell to 13.8. In the depths of the March 2020 sell-off, as the onset of the Covid-19 pandemic brought swaths of the economy to a halt, the index traded at 13.4 times its expected earnings .

“Markets don’t typically bottom out near historical medians,” said Greg Swenson, portfolio manager at Leuthold Group. “They tend to overvalue on the downside from a valuation perspective.”

Adding to concerns among stock market investors, many have begun to worry about the threat that corporate earnings are under threat, suggesting that valuation measures based on earnings projections may underestimate the true price of stocks. U.S. businesses have warned of challenges on multiple fronts, from rising costs to lower exchange rates due to a stronger dollar.

“These valuation multiples are based on a seriously overly optimistic earnings outlook,” Swenson said.

Another valuation model, the Buffett indicator, compares the value of publicly traded companies in the United States with the gross national product of the country. As of the end of last week, one version of this metric was 29% above its historical average and above its peak from the dot-com bubble days of 2000, suggesting the market is overvalued. The metric was named after Warren Buffett, who once called the indicator “probably the best single measure of where [stock market] valuations hold at some point.

Two recent surveys have shown signs of rising consumer long-term inflation expectations. Fed officials have said they would want to react aggressively to signs that these expectations are rising or “unanchoring” because they believe the process of extracting inflation from the economy will become much more difficult. if this happens.

Deutsche Bank economists said they expect the Fed to hike rates another 0.75 points at its July policy meeting, which would put the Fed on track to raise. rates much closer to levels designed to actively slow the economy by the end of this year. .

These measures are “more consistent with… our own view that restrictive policy is necessary to control inflation,” wrote Matthew Luzzetti, chief US economist at Deutsche Bank. “Such a move will also help bolster the credibility of the Fed that the monetary policy stance is rapidly adjusting to a new reality of persistently high inflation.”

Write to Karen Langley at karen.langley@wsj.com and Nick Timiraos at Nick.Timiraos@wsj.com

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