Markets responded negatively to the latest Fed increase, with the S&P 500 declining 6.4% so far in September and 22.9% so far this year. Steep and sudden rate increases impact markets in multiple ways. First, higher rates produce lower valuations when calculating the present value of a stream of earnings. Second, higher rates increase the cost of doing business for most commercial ventures and certainly increase the cost of any new investment by those firms. Third, as higher rates increase the value of the dollar relative to other currencies, global sales become more costly for foreign buyers, and foreign earnings are converted back to dollars at disadvantageous rates. Finally, if the higher rates do precipitate a recession, stock prices need to reflect the impact of such a recession on future earnings.
So far this year, corporate earnings have generally been positive, but these results are increasingly being reported with warnings from business leaders about the headwinds associated with inflation, the supply chain problems, and consumers squeezed by inflation. Overall earnings for the S&P 500 have been up, however, if you strip out profits from energy companies, much of the gain evaporates. The current price earnings ratio for the S&P 500 is 18.7, well below its recent spike above 30 but also above the long-term average of 16. So, stocks are cheaper than they have been in recent times but not yet truly cheap in absolute terms.
Earnings, like so many other measures, are backward-looking. If some of the effects of higher rates and slower growth are still working their way through corporate earnings, there may be more downside before they support another bull run. However, markets also try to anticipate economic developments well in advance, and if inflation starts to respond to this more restrictive environment in the coming months, we may also get through the worst of the current market adjustments over the next couple of quarters.
Source: S&P Dow Jones Indices LLC, fred.stlouisfed.org
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