Two Perspectives on the Sell-Off

by Erik L. Knutzen, CFA, CAIA, Chief Investment Officer—Multi-Asset Class, Neuberger Berman

We see signs that many investors are changing the way they think about the current sell-off—and that might challenge the way you think about the balance of risk.

“Are we there yet?” asked Joe Amato two weeks ago, as the S&P 500 Index clocked up six consecutive weeks of losses and investors were feeling for the bottom of the sell-off.

His conclusion: in the face of an inflationary slowdown, caution—with a tilt toward defensive, quality and lower-beta stocks—was still prudent. The S&P 500 went on to post a seventh week of losses, dipping briefly into bear-market territory on the way.

So…are we there yet?

Here, we offer some observations about the market pricing relationships that the Neuberger Berman Multi-Asset team has been watching. What we’ve seen suggests that, over the past two weeks or so, many investors have changed the way they frame this question—and that might challenge the way you think about the current balance of risk.

Real Yields

At the end of last year, my colleague Robert Surgent wrote a prescient article arguing that “the level of real rates will be the primary determinant of asset class performance,” and that a move upward in real rates would “have large consequences.”

The 10-year U.S. real yield has since ascended rapidly, from -1.00% to a high of +0.35% on May 10. Sure enough, equity markets have slumped.

But look closer, and Bob’s prediction was even more striking.

When we look at the relationship between the U.S. 10-year real yield and the S&P 500 Index forward price-to-earnings multiple going back to 2018, a -1.00% real yield implies a multiple of 23 times. That is roughly where the multiple sat at the end of last year. A 0.35% real yield implies a multiple of 17 times, according to this relationship—approximately the level to which the Index valuation had fallen by mid-May.

In other words, at the start of the year, if you knew real yields would be at 0.35% in mid-May, you could have used this historical relationship to predict where the price/earnings ratio for the S&P 500 would be, too. According to this framework, Russia’s invasion of Ukraine, China’s COVID-19 lockdowns, runaway inflation—none of it mattered relative to investors pricing for tighter financial conditions as central banks committed to remove record levels of COVID-driven stimulus. This led to the experience of stocks and bonds falling in tandem over this period.

Real yields and broader measures of the monetary policy environment, such as the Goldman Sachs U.S. Financial Conditions Index, are now back at pre-COVID levels. If the correction for pandemic-era looseness is done, or at least largely priced in anticipation of central bank actions, and if the 2022 market decline is exclusively about tighter financial conditions, does that leave us with more upside than downside risk in equities ahead?

Earnings

Maybe. But what if it’s only the P/E ratio that has bottomed out, and the “E” is about to fall?

This would reverse what happened during 2020 and 2021. When the pandemic struck, earnings declined, but stock markets quickly started to climb, and over the next two years earnings grew into those higher valuations. Since the start of 2022, valuations have slumped; are earnings going to shrink into them?

We see signs that many investors have started thinking along these lines. They no longer appear to be simply re-valuing positive profit growth over the coming year, but now questioning those earnings outlooks.

For example, during the nine days before the S&P 500 hit its recent low, real yields fell and bond prices rose, reversing the positive price correlation between stocks and bonds so far this year. The index’s seventh consecutive down week, which included a 4% decline in a single day, appeared to be associated, not with hawkish Fed messaging or rates news, but with major misses and downward revisions for earnings, margins and subscriptions, coming not only from long-duration technology companies but from high-quality consumer and retail giants.

If earnings growth is going to fall from here, that leaves us with a very different balance of upside and downside risk. Assume that estimates for S&P 500 earnings over the next 12 months decline from the current level of $245 per share to, say, $210. Then assume the P/E ratio remains unchanged. The Index would shed another 10%.

Conviction

So, the answer to that question—“Are we there yet?”—now depends on your confidence in the U.S., and global, economy to absorb the projected tightening of financial conditions with a mid-cycle slowdown rather than a full recession. If you have strong conviction on that, then we are closer to the equity market bottom and the downside versus upside risk relationship has begun to shift more favorably; but if we are going into recession, there is very likely more downside risk as markets could price in lower earnings even if valuations do not get cut further.

As Joe pointed out, the Asset Allocation Committee’s base case remains that the U.S. can avoid a recession in the coming year, but we also acknowledge that the probability has increased. The range of potential outcomes for equity markets over the next 12 – 18 months therefore remains wide, in our opinion. We may not be as bearish as when the S&P 500 P/E ratio was over 20, but we do not think this is a time to make big bets.

As such, we still favor defensive, quality and lower-beta stocks. But now is the time to be especially vigilant, and perhaps to change the focus of attention. If the first five months of the year were about real yields and long-duration stocks, the remainder may be about the broader market and more fundamental indicators, such as Purchasing Managers’ Indices, earnings outlooks, consumer confidence and real-time alternative data on consumption patterns. Here is where we think clues are likely to be found as to whether equity markets are bottoming out or have further to fall.