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With the S&P/500 index down 21% per cent so far in 2022, investors are asking when will the market finally reach a bottom. There's no definitive answer, but these three charts suggest there is further pain ahead.

With the S&P/500 index down 21% per cent so far in 2022, investors are asking when will the market finally reach a bottom? There’s no definitive answer. But these three charts suggest there is further pain ahead. All are based on the US markets, however, the insights remain useful for Australian investors.

1. Hopes and Dreams 

Figure 1 by Arbor Research segments the valuation of the S&P/500 Index into:

• Book Value (Red) – what is left over when a company sells all assets and pays all outstanding liabilities. Akin to a liquidation value.
• Near-term earnings (Blue) – the next three years of earnings discounted back to today

• “Hopes and dreams” (Yellow) – the remainder of valuations unexplained by the first two categories

The clear trend over the past ten years is that valuations have baked in greater relative amounts of future expectations indicating market exuberance. A similar trend occurred in 2000, before the dot-com crash and in 2008, before the global financial crisis. Despite the recent market capitulation, there is plenty of valuation compression to occur before returning to historical levels.

It should be said the chart is somewhat misleading, given it doesn’t account for intangible assets or earnings from year four onwards. Nonetheless, it demonstrates the willingness of investors to accept future earnings rather than the here and now.

2. Margins and sentiment

Chart two compares corporate gross margins (revenue divided by the direct cost of producing the product) against consumer sentiment.

The historical trend has been that gross margins largely move in tandem with consumer sentiment. When financial conditions such as interest rates and inflation are stable, consumers feel good and spend. Subsequently, corporates can retain or grow gross margins and pass on any cost increases in raw materials. However, when sentiment shifts, consumers begin to tighten their belts. Unless a business has pricing power, gross margins begin to come under pressure as inflation cannot be passed-through.

However, corporates have never been more profitable. This is largely due to pandemic-induced demand that is now rolling-over in addition to elevated commodity prices. It’s likely that as margins mean-revert, earnings will begin to fall and the gap narrows.

3. Inflations impact valuations

The final chart by Schroders plots the average price-to-earnings (P/E) multiple of the US market against the annualised inflation rate.

The trend shows that as the inflation read increases, the lower the P/E ratio for the market. This in itself is not terrible. But when you go from very low inflation to very high inflation, as the world has done over the past 12 months, this chart suggests markets will fall quickly.

The current P/E of the US market, depending on what measure you use, is around 20. Given inflation came in at 8.6 per cent in the US, this implies a market multiple of 12, or a 40 per cent downside. If that sounds bad, remember we’ve already deduced in chart 2 that earnings will also fall in the near future. Chart 1 also confirmed the valuations look stretched, despite the losses already incurred in 2022.

The result, should the three charts prove correct, will be a double-whammy of compressed valuations and earnings revisions. That does not bode well for the S&P/500.

Australia relatively better placed

Returning to Australia, the local index shares some similar characteristics. Consumer sentiment is low as households react to the first series of interest rate increases since 2010. Profit margins also remain elevated, particularly in the retail and discretionary sectors.

But inflation is only 5.1 per cent, implying a P/E multiple of around 15. The S&P/200 is currently at 16, suggesting that most of the multiple compression has already taken place. There is some earnings downside if commodity prices sell-off, but fortunately, Australia is relatively better-positioned compared to the United States.

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