The second quarter of 2022 was a very challenging environment for equities, contributing to an overall ugly first half of 2022. The S&P 500 posted the worst 6-month start to a year since 1970, with a 19.74% decline.  

Market Synopsis:

There were 3 main factors behind the massive decline of the U.S. stock market: i) Russia-Ukraine war, ii) China lockdown and iii) Federal Reserve’s fight against inflation. i) The prolonged Russia-Ukraine war and resulting sanctions from Western countries has led to elevated oil and energy prices. Higher energy costs lead to higher production costs and ultimately affect profit margins of companies. ii) During Q2 of 2022, China remained locked-down due to its zero-Covid policy, resulting in continued supply chain disruptions and weak economic activity. iii) The Federal Reserve has set out to combat the record-high inflation by aggressively raising the federal funds rate and quantitative tightening to increase borrowing rates. The market fears that these actions are ineffective to control inflation, yet can send the U.S. economy into a recession (a scenario known as stagflation - high inflation and weak economic growth). 

The above-mentioned factors and subsequent investor fears have led to a multiple compression process, in which investors want to pay less premium for the projected earnings. The forward Price-to-Earnings (P/E) multiple of the S&P 500 declined from 22x in 2021 to now 15x. This means while in 2021, investors were willing to pay 22 times the forward projected earnings, at the moment, investors are only willing to pay 15 times. This happens because the cost of capital has increased, making the earnings less attractive and/or fears that the earnings could be less than projected because of a recession.

Market Outlook:

From a valuation perspective, we believe the multiple compression process is likely done, because the current 15.4x forward P/E multiple is a fair value. 15.4x is slightly below the 15.8x that the S&P 500 has traded at, on average, in the past 15 years (see chart below). Historically, 15.4x is cheaper than 2019 pre-Covid (18x), cheaper than 2014-2019 post-Great Recession, and at par with 2009-2010 during the Great Recession. At this valuation level, we argue most of the bad news (recession) has been priced in, and leaves open two possible outcomes that are both favorable: i) a recession occurs, but since it has been priced in, there will not be additional downside, or ii) the recession doesn’t occur or occurs very mildly.

Additionally, history is on the long side. The last time the S&P 500 fell 21% in the first half of the year was 1970. This was also during a period of high inflation that the current economy has been compared to. It ultimately gained 27% during the second half of that year (see chart below). As a result, the odds are looking good for the second half of 2022, since the market has already priced in the probability of a recession.  

Forward Guidance:

We lay out three cases for the S&P 500. 

Bull Case: S&P 500 ends 2022 at $4680

We assign a 30% probability for the S&P 500 to end the year at $4680 (+22% from current level). This reflects a 2019 pre-pandemic valuation multiple of 18x forward P/E, on current earning estimates of 260$/share. 

Neutral Case: S&P 500 ends 2022 at $4100

We assign a 50% probability for the S&P 500 to end the year at $4100 (+7% from current level). This reflects a 15-year average valuation multiple of 15.8x forward P/E, on current earning estimates of 260$/share. 

Bear Case: S&P 500 ends 2022 at $3600

We assign a 20% probability for the S&P 500 to end the year at $3600 (-6% from current level). This reflects the current valuation multiple of 15.4x forward P/E, on earning estimates that will be revised down to 234$/share due to a recession.