Welcome to the first edition of the Equity Beat!
I am very excited to provide for you a regular cadence of thoughts on equity markets broadly, and individual stocks more specifically, that reflect the conversations, interactions and analyses covered by our Equity Research team. The good news (for me) is that there is always something interesting to write about related to public equities; the challenge is how to differentiate our content from a rather saturated market of information. Our primary response is that our team of more than 50 thoughtful investors evaluating several hundred companies across the globe provide an extraordinarily wide top-of-funnel mechanism from which to compose an insightful post worthy of your time and mindshare. Our secondary response is that we will attempt to keep topics entertaining such that you’ll be as interested in the final word of the post as the first. And with that relatively concise introduction, let’s get this show on the road…
Briefly looking back at 2022, the S&P 500® Index declined by nearly 20%, explained in full (and then some) by forward P/E multiple contraction of nearly 25%—from 21.7x at the beginning of the year to 16.6x by year-end. The rise in the 10-year Treasury yield from 1.5% to nearly 3.9% at year-end can largely explain the compression in valuation, especially for higher multiple equities, primarily during the first half of the year. As dreary as equity returns were last year, the second half was effectively flat for the S&P 500 Index.
Tough Year
The S&P 500 Index dropped more than 20% last year, driven primarily by rising interest rates and despite the fact that forward earnings estimates did not fall by nearly as much.
| S&P 500 Return | P/E Ratio | 10-Yr U.S. Treasury Yield | |||
|---|---|---|---|---|---|
| 2022 By Quarter: | Start of Quarter: | End of Quarter: | Start of Quarter: | End of Quarter: | |
| Q1 | -5.2% | 21.7x | 20.2x | 1.51% | 2.32% |
| Q2 | -16.6% | 20.2x | 15.2x | 2.32% | 2.97% |
| Q3 | -5.2% | 15.2x | 15.8x | 2.97% | 3.80% |
| Q4 | 5.9% | 15.8x | 16.6x | 3.80% | 3.88% |
Source: FactSet as of 12/31/2022
When analyzing rate hiking cycles that have occurred over the past 30 years, it has generally behooved investors to be patient – markets rebounded nicely following most cycles, but only after the final rate hike occurred. With the majority of Fed rate hikes for this cycle now likely in the rearview mirror, investors have shifted their focus towards earnings – specifically how far expectations need to fall before the market reaches its nadir. While we are (rightfully) not in the business of timing markets, it’s worth studying history to consider the relationship between earnings estimate and equity market directionality.
Since 1995, there are four rather distinct periods during which forward earnings estimates for the S&P 500 Index declined, tied to a specific event and/or economic downturn. Below, we describe each period, and present the magnitude of that drop in earnings expectations. Further, stock markets tend historically to move in advance of changes in economic activity or earnings trajectory, not in response to those changes. But by what duration? And by how much?
When Earnings Falter
There haven’t been many periods in recent history when forward earnings estimates for the S&P 500 Index have dropped notably. Below we list the four primary examples. In all of these examples, forward earnings estimates bottomed out just a few months after the trough in the index price, and in all four periods the index rebounded strongly during that short time window.
| When Did the Decline in Earnings Estimates* Occur? | How Steep Was The Decline? | How Long Between The Trough In the Index Price, and the Trough in Earnings Estimates? | How Did The Index Perform? | |||||
| Description | Peak Month* | Trough Month* | Change in Earnings Estimates | Date When S&P 500 Index Price Hit Bottom | Date When S&P 500 Earnings Estimates Hit Bottom | Number of Days | S&P 500 Return During That Period | |
| Asian Financial Crisis/Russian debt default | September 1998 | December 1998 | -2.2% | 8/31/1998 | 12/31/1998 | 122 | 28.4% | |
| Dot-com hangover/9-11 | October 2000 | December 2001 | -16.5% | 9/21/2001 | 12/31/2001 | 101 | 18.9% | |
| Great Financial Crisis | October 2007 | April 2009 |
-39.0% | 3/9/2009 | 4/30/2009 | 52 | 29.0% | |
| COVID-19 | January 2020 | May 2020 | -20.3% | 3/23/2020 | 5/31/2020 | 69 | 36.1% | |
Source: FactSet as of 12/31/2022. *Analysis looks at consensus forward P/E ("NTM EPS") estimates, which are collected and updated monthly in Factset
There are two primary conclusions to come out of this analysis:
- Over these four periods, the average time between the stock market bottom and earnings estimates bottoming is less than three months.
- Over these four periods, the average market return from point to point is 28%.
Since peaking in June 2022, the S&P 500 Index’s forward EPS estimate has declined by just 4%, although many market pundits anticipate a peak-to-trough estimate decline closer to the level experienced during the dot-com hangover (which would put forward S&P 500 Index EPS estimates at about $200, down from $230 currently). On paper, that looks fairly concerning, and at current market levels would equate to a 19x P/E multiple.1 Yet, it’s not uncommon for the market multiple to expand during a recession, given both the heavy economic cyclicality of certain sectors of the economy, as well as the expectation of a drop in the 10-year yield (along with a more dovish Fed). During three of the four periods mentioned, the forward P/E for the index was above 20.0x when estimates hit their trough point; the lone exception was in the wake of the Great Financial Crisis, when both fundamentals and sentiment were at some of the lowest levels in memory.
In truth, there remain a lot of variables we don’t and can’t know in the current cycle, or in any cycle for that matter. When will rates peak and at what terminal rate? How far will corporate estimates drop in the upcoming earnings recession, and by when? How will inflation and unemployment levels behave, and how will that instruct the Fed’s future actions?
What we do know is that over long periods, S&P 500 Index earnings have grown at a mid-to-high-single digit rate per year on average, as have equity markets. Based on historical precedent, we believe it would be imprudent to wait until the economy and corporate earnings expectations bottom before getting back into the market in the event you timed things right and sold 12 months ago…or if you’re highly concerned about the trajectory for earnings today.
Thanks for reading, and remember to never skip a Beat - Eric 
1 Source: Factset and Brown Advisory calculations
The views expressed are those of the author and Brown Advisory as of the date referenced and are subject to change at any time based on market or other conditions. These views are not intended to be and should not be relied upon as investment advice and are not intended to be a forecast of future events or a guarantee of future results. Past performance is not a guarantee of future performance and you may not get back the amount invested. The information provided in this material is not intended to be and should not be considered to be a recommendation or suggestion to engage in or refrain from a particular course of action or to make or hold a particular investment or pursue a particular investment strategy, including whether or not to buy, sell, or hold any of the securities mentioned. It should not be assumed that investments in such securities have been or will be profitable. To the extent specific securities are mentioned, they have been selected by the author on an objective basis to illustrate views expressed in the commentary and do not represent all of the securities purchased, sold or recommended for advisory clients. The information contained herein has been prepared from sources believed reliable but is not guaranteed by us as to its timeliness or accuracy, and is not a complete summary or statement of all available data. This piece is intended solely for our clients and prospective clients, is for informational purposes only, and is not individually tailored for or directed to any particular client or prospective client.
The S&P 500 Index represents the large-cap segment of the U.S. equity markets and consists of approximately 500 leading companies in leading industries of the U.S. economy. Criteria evaluated include market capitalization, financial viability, liquidity, public float, sector representation and corporate structure. An index constituent must also be considered a U.S. company. Standard & Poor’s, S&P, and S&P 500® are trademarks/service marks of MSCI and Standard & Poor’s.
Factset® is a registered trademark of Factset Research Systems, Inc.
Price-Earnings Ratio (P/E Ratio) is the ratio of the share of a company’s stock compared to its per-share earnings. P/E calculations presented use FY2 earnings estimates; FY1 estimates refer to the next unreported fiscal year, and FY2 estimates refer to the fiscal year following FY1.
Forward EPS is the ratio of projected earnings to number of outstanding shares of a company.