Open with Markets in Motion page.
Welcome to RBC’s Markets in Motion podcast, recorded September 25th, 2022. I’m Lori Calvasina, head of US equity strategy at RBC Capital Markets. Please listen to the end of this podcast for important disclaimers.
This week in the podcast, we reflect on some of the most interesting questions we got and things that we saw last week. Three big things you need to know: First, positioning trades within US equities tend to be fairly mixed during yield curve inversions (a topic of focus in our investor meetings even before the FOMC) but have a classic defensive bias. Second, an S&P 500 P/E of ~16x seems reasonable based on post-FOMC interest rate and inflation views and our analysis of the relationship between rates, inflation, and P/Es dating back to the 1970s. Third, the 3,500 level on the S&P 500 will be key to watch as it represents the point at which a median recession would be priced in and the S&P 500 P/E based on 2023E EPS would fall below average again, using our below-consensus EPS forecast of $212.
If you’d like to hear more, here’s another five minutes. While you’re waiting, a quick reminder that you can subscribe to this podcast on Apple, Spotify, and other major platforms. Now, the details.
Flip to slide 2
Let’s start with Takeaway #1: Positioning Trades Within US Equities Have Been Mixed During Yield Curve Inversions, With A Bias Towards Defensive Groups As Recession Fears Mount
- We were on the road last week. Before Wednesday’s FOMC decision, the investors we spoke with were already focused on the yield curve, and pondering the question of how to be positioned during inversions. This has historically been a tricky issue for equity investors. Brief inversions have seen the S&P 500 rise more often than not. In extended inversions the S&P 500’s track record has been mixed.
Flip to slide 3
- What’s clear when we look at industry groups, however, is that recession fears dominate and drive positioning trades. While leaders and laggards during these periods aren’t highly consistent, areas with a tilt towards outperformance tend to be defensive and include Commercial & Professional Services, Food & Staples Retail, HH & Personal Products, Materials, Pharma/Bio/Life Sciences, Software & Services, Telecom, Transports & Utilities. Areas that show the greatest tendency to underperform include Consumer Services, Energy, and Tech Hardware & Equipment. While much of this is obvious, it helps explain the sharp drop in Energy stocks at the end of the week.
Flip to slide 4
Moving to Takeaway #2: An S&P 500 P/E of ~16x Seems Reasonable Based on Our Analysis of Multiples vs. Rates & Inflation Back to the 1970s
- Even before Wednesday’s FOMC decision, the investors we spoke with were also focusing on valuations and what higher-for-longer rates might mean for P/E multiples. We highlighted our analysis on the relationship between core PCE and the average S&P 500 trailing 4Q P/E back to the 1960s, which has been anticipating a ~16x P/E at YE 2022 based on the assumption that core PCE would end the year around 4.5%. That stat has been the consensus among street economists recently, and also happened to be the expectation for 2022 in last week’s Summary of Economic Projections.
- This weekend we took a trip down the valuation rabbit hole and fine-tuned a model we’ve been working on that forecasts a YE 2022 S&P 500 P/E based on expectations for 10-year yields, Fed funds, core PCE, and PCE leveraging data back to 1970. We plugged in 2022 expectations on inflation and Fed funds from last week’s SEP and 3.4% on the 10-year (which assumes 10-year yields will come in a bit due to recession concerns). The model anticipates a P/E of 16.35x for a 57% contraction from the pandemic high of 37.8x – close to the contraction that was seen in the 1970s and after the Tech bubble. If the S&P 500 were to trade at 16.35x on our 2022 EPS forecast of $218, the index would fall to 3,564.
- That’s not to say 16x has to be the floor. A 63% contraction, like that which was seen in the 1970s, would take the P/E to 14x, implying a move to 3,052.
Flip to slide 5
- Additionally, when used the relationship between rates and inflation and P/E’s in the 1970’s and early 80’s to come up with potential P/Es for YE 2022, our various backtests came up with a range of 12x to 16x. Core PCE did the best job of predicting P/E’s back in that time period, and that model points to a P/E of 13.4x for this year based on the 4.5% Fed prediction.
Flip to slide 6
Wrapping up with Takeaway #3: The 3,500 Level on the S&P 500 Will Be Key To Watch In the Weeks Ahead
- With investor sentiment (both retail and institutions) at the low end of its historical range, and in the case of retail at GFC lows, (flip to slide 7)
- ….the equity put/call ratio ending the week at its highest level since the pandemic (and approaching December 2018 high), (flip to slide 8)
- …and stocks already baking in a big spike in jobless claims, we think stocks are on the cusp of an important test.
Flip to slide 9
- While the June lows now seem unlikely to hold, if the S&P 500 experiences its typical recession drawdown of 27%, the index will fall to 3,501.
Flip to slide 10
- Additionally, the S&P 500 forward P/E is starting to get close to its long-term average on 2023’s EPS using our below-consensus forecast of $212. It closed on Friday at 17.4x, and the average has been 16.8x.
- Assuming our $212 estimate is in the right neighborhood (bottom-up consensus is still $242), it will break below average if the index hits 3,561. That may open the door for bargain hunters, though fundamental catalysts for a move higher – other than the midterms – admittedly are hard to identify.
That’s all for now. Thanks for listening. And be sure to check out our sister podcast, RBC’s Industries in Motion, for specific thoughts on sectors from RBC’s team of industry analysts.