The S&P 500, often called the benchmark of the U.S. stock market, is made up of the 500 largest and best-performing companies listed on U.S. exchanges. Approximately 25% of this index is made up of "big tech" stocks such as Meta (FB, Financial), Apple (AAPL, Financial), Amazon (AMZN, Financial), Alphabet (GOOG, Financial)(GOOGL, Financial) and Tesla (TSLA, Financial). This index is a great tool that we can utilize to figure out general market sentiment.
Since December 2021, the S&P 500 has declined from all-time highs of 4,766 points. Since then, it is down ~16.7% at the time of writing. We are teetering on the edge of a bear market, which is categorized by a decline of 20% or more. The real question, is how low will the S&P 500 go this time? Are we in a correction or a recession? There's no way to know in advance, but we can analyze historical data to see the likely scenarios.
How often does the stock market correct?
According to one study by global asset management firm Guggenheim, since the post-WWII era there have been the following market declines:
84 pullbacks of 5% or more
29 corrections of 10% or more
9 bear markets of 20% or more
3 bear markets of 40% or more.
Thus, the S&P 500 has a correction (10%+) every 2.7 years on average.
The S&P 500's performance will be governed by two main factors moving forward: inflation and earnings. I categorize everything else as falling into one of these two categories; for example, money-printing and interest rates fall under the inflation category.
Inflation
The annual inflation rate in the U.S. came in at 8.3% for April. This is much higher than the Federal Reserve's 2% target, but the good news is this is down slightly from the 41-year high of 8.5% seen in March.
High inflation generally means higher input costs for businesses, which include labor and material costs. This can also mean rising food and energy prices, which lower household income and thus affect the consumer's spending power.
In order to tame inflation, the Fed can raise interest rates, which they have done recently by 0.5%. Economists forecast the Fed to raise interest rates seven times in 2022, reaching 2.9% in early 2023.
Higher interest rates means mean higher discount rates for stock valuations, which also compresses earnings multiples. We have already seen the market bake rate hikes into stock prices. This was done at the first sign of trouble in February 2021, where growth stocks were the leading indicator. Then in November 2021, when the world realized inflation wasn't going to be transitory, further rate hikes were baked in and the stock market took a dive as valuation multiples compressed.
Earnings
The second factor we can analyze is the earnings of the companies in the S&P 500. According to Factset, the percentage of S&P 500 companies beating EPS estimates is greater than the five-year average, which is good news. However, the index is reporting single-digit earnings growth for the first time since the last quarter of 2020. This is mainly driven by macro headwinds and unusually high earnings growth in the first quarter of 2021 thanks to stimulus and the economy reopening.
The green bars on the chart below indicate the percentage of companies which have beat analysts' expectations for earnings. This is broken down by sector, and as we can see, 79% of S&P 500 companies (middle column) have beat earnings expectations.
Moving forward, analysts from Factset are predicting earnings growth of 10.1% for the calendar year of 2022. The key to the stock market recovery moving forward will be the balancing act between inflation and earnings growth. If earnings growth stays above inflation, then that is a major positive, but if earnings drop or inflation continues to rise, then we could get a deep bear market or recession. But it must be noted the data and analyst predictions don't currently expect this. Most analysts believe earnings will continue to grow and inflation will decrease, resulting in a growth scenario.
The worst case situation is stagflation, which occurs when earnings growth slows or decreases while inflation continues to rise. This leads to high input costs for businesses and higher costs for households, which results in less consumer spending and can spiral into a recession. This could even result in a "lost decade" like in the 1970s. The 1970s stagflation was due to a few factors, such as high oil prices from the Arab oil embargo, high unemployment and low earnings growth. However, in today's situation, we have low unemployment (back to pre pandemic levels of 3.6%), high earnings growth and the U.S. is now one of the largest global suppliers of oil. Thus, I don't think we are at risk of a recession yet.
Final thoughts
The economy is a complicated collection of individual spending habits and macroeconomic forces. When trying to determine whether a bear market is imminent, we can look at two main factors for hints. The first is inflation, while the second is the earnings growth of companies. Currently, the stock market correction we have seen has been driven by the first factor; we are seeing a compression in valuation multiples driven by high inflation and forecasted rate hikes.
The forward 12-month price-earnings ratio of the S&P 500 stocks is 17.6, which is below the five-year average of 18.6 but still above the 10-year average of 16.9. This suggests the stock market is still not "cheap" relative to the 10-year average and could correct a little more. The good news is we are seeing low unemployment, greater than expected earnings growth and inflation has ticked down slightly (though it is still very high).
