The 12-month-forward consensus earnings-per-share forecast for the S&P 500 Index has maintained an upward trend this year thanks to consistent demand and stronger corporate pricing power in a rising inflation environment. The disconnect between market and analysts’ views implies that the entire equity market sell-off to date is attributable to valuation contraction. Should analysts revise earnings forecasts lower in anticipation of slowing growth, prices would have to fall further to maintain current valuations.
But equity prices are based on more than just the next 12 months’ earnings, said Ian Kresnak, a Vanguard investment strategist and a member of the Vanguard Capital Markets Model® (VCMM) research team.
“The market is able to look through fluctuations in the business cycle and focus on long-term growth potential,” Kresnak said. “Valuations—the price investors pay for a dollar of earnings—are explained by the expectation of long-term earnings growth as well as by economic factors such as interest rates and inflation. The market could already be pricing in some downward revision to 12-month-forward earnings. Vanguard recommends that investors instead focus on longer-term earnings estimates when setting return expectations.”
Vanguard’s analysis found that the rise in interest rates and inflation explains some of the S&P 500 Index’s 13.3% decline from the start of the year through July. “Given that the market seems to believe that the Federal Reserve won’t raise interest rates as high as once expected because of falling inflation and rising recession risks, part of the sell-off could be due to the market’s expectation for lower earnings in the case of a recession,” Kresnak said. “In that case, forward earnings would have to fall by more than what is priced in to warrant further sell-off, barring further deterioration of market sentiment.”