Frankly, this has been a terrible year for Wall Street. The standard S&P 500 (SNPINDEX: ^GSPC) showed the worst performance for the first half of the year since 1970. We’ve also seen the index lead Wall Street higher since the coronavirus crash in 2020, Nasdaq Composite (NASDAQINDEX: ^IXIC)has fallen 34% since November.
The impetus for these moves is historically high inflation, which reached an incredible 9.1% in June 2022, Russia’s invasion of Ukraine, which is further crippling global energy supply chains, and the Federal Reserve’s aggressive monetary policy changes. The Fed raised the target federal funds rate by 75 basis points at consecutive meetings.
Now we can add a new catalyst to the list: “recession” … of sorts.
Are we in a recession? It really depends on your school of thought
For many investors, there is a broad definition of what a recession it became accepted. With US gross domestic product (GDP) recovering for two consecutive quarters, it is widely believed that the US economy is in recession.
In late June, the Bureau of Economic Analysis (BEA) released its final estimate of US GDP for the first quarter, which showed a decrease of 1.6%.. On Thursday, July 28, 2022, the BEA released its preliminary estimate (essentially the first early look) of US GDP for the second quarter, which showed a contraction of 0.9%. Cross the T’s and dot the I’s and it sure looks like a recession for the US economy.
However, technically a recession is not just two consecutive quarters of falling GDP. Officially a committee of eight economists it is the part of the National Bureau of Economic Research (NBER) that decides whether a recession is occurring or not. While GDP is one of the factors considered, this committee also takes into account consumer spending, retail sales, employment data (both non-farm employment and household surveys), personal income and industrial production. The NBER is the official arbiter of whether the US is in a recession.
For example, data on retail sales and employment cannot paint a picture of the US recession. The Commerce Department noted in its press release in mid-July that retail sales rose 1% in June and fell by a revised 0.1% in May. This suggests that consumers are still spending freely. Then again, when prices for goods and services are skyrocketing, what choice do consumers have but to open their wallets a little wider?
The US unemployment rate is also historically low at 3.6% in June 2022. We typically see evidence of job losses and rising unemployment during recessions.
Wall Street may have a lot more to worry about than whether we’re in a ‘recession’
While the “R” word (recession) is usually enough to shake Wall Street’s confidence, there’s a much bigger concern at the heart of it that has the potential to send the S&P 500 and Nasdaq Composite significantly lower. I’m talking about Schiller price-earnings (P/E) ratio..
My guess is that most investors are relatively familiar with the P/E ratio. You take the stock price of a public company and divide it by that company’s earnings per share over the last 12 months. The P/E ratio is a valuation tool that can be used to compare with similar companies or perhaps the broader market to determine whether a stock is “cheap” or “expensive.”
The Shiller P/E ratio, also known as the cyclically adjusted price-to-earnings ratio (CAPE ratio), takes into account earnings adjusted for inflation over the last 10 years. It’s a broader view of the broader market – specifically, at S&P 500 – has led over the past decade in terms of valuation.
Here’s an interesting thing about the Shiller S&P 500 P/E ratio: Bad things happen above 30.
Shiller’s average P/E ratio since 1870 is 16.96. As of this writing on July 29, 2022, it is 30.55. But it is not only the current value that is alarming. This is what happened every time the Shiller P/E ratio exceeded 30, and it’s also what the earnings forecast (the “e” component) expects for many of Wall Street’s most important businesses.
They have existed since 1870 there were only five cases where the Shiller S&P 500 P/E ratio exceeded and held above 30:
- 1929: The Great Depression led to Dow Jones industrial index (DJINDICES: ^DJI) lose almost 90% of its value.
- 1997-2001: The S&P 500 Shiller P/E reached its all-time high above 44 during the dotcom boom. Eventually, the S&P 500 will lose almost half its value.
- Q3 2018: During the third quarter of 2018, the Shiller P/E ratio climbed back above 30. The S&P 500 lost 20% of its value in the following quarter.
- Q4 2019-Q1 2020: The S&P Shiller P/E’s next rise above 30 was derailed by the COVID-19 crash, which cost the S&P 500 34% of its value over 33 calendar days.
- Q3 2020 to date: The S&P 500 Shiller P/E peaked just above 40 in January 2022. Since then, the S&P 500 and Nasdaq Composite have entered bear market territory.
Although ease of access to information has over time made the investment community more tolerant of risk and higher P/E ratios, history makes it pretty clear that bad things happen when the S&P 500 Shiller P/E exceeds 30 (as it does now).
To make matters worse, the flurry of earnings reports showed that the “E” component of earnings is deteriorating. With a number of major publicly traded companies missing Wall Street’s second-quarter expectations or offering subdued growth forecasts for the third quarter or the rest of the year, Shiller’s P/E ratio could potentially increase.
While the valuation alone is rarely enough to send the stock market lower, the tea leaves say it’s a data point you shouldn’t ignore.
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