The entire move lower in stocks this year is because investors are willing to pay less for every dollar of a company’s earnings. At the start of 2022, investors were willing to pay 22.5 times for every dollar of S&P 500 earnings expected over the next twelve months. Today, investors are only willing to pay 16 times. This is the often-quoted “price-to-earnings ratio” (P/E) of the stock market. Said another way, the “P” has come down, but the “E” has not budged.
We find it curious that, even as the economy noticeably slows, there has been no reduction in the level of earnings analysts expect companies to generate. We think that is coming and we believe that is the biggest risk to stocks going forward.
The average earnings decline during the past three recessions has been about 22%. To be fair, two of the last three recessions were severe, and we don’t know with certainty that a recession is currently in the cards (although the probability is higher than normal). In the event of a modest 10% decline in earnings expectations, stocks will fall another 10%, holding P/E multiples constant. Given our belief that economic growth will continue to slow, we think it is likely analysts will begin to adjust corporate earnings expectations lower. At the very least, this will be a headwind to stocks recovering to old highs any time soon.
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