Market valuation ‘hard’ correction risk rises, says Deutsche Bank – here’s why

The warning comes as Wall Street companies have expressed nervousness as stocks continue to rally, pushing major indices to all-time highs, without any significant pullbacks. On Friday inclusive, the S&P 500 spent 214 trading days without a 5% decline, rising more than 33% in that time frame. This is the longest period of no decline in a 404-day period that ended on February 2, 2018, according to Dow Jones Market Data.

Should know: This Wall Street firm is sticking to its S&P 500 price target. Here’s why a correction is said to be late.

The main indices were on course to lose ground for the week of Friday, with the S&P 500 SPX,
-0.77%
and Dow Jones Industrial Average DJIA,
-0.78%
threatening to extend a losing streak to five sessions. The S&P 500 is only down 1% from a near record high on September 3 and more than doubled from its pandemic low in March 2020.

Chadha noted that although stocks are “very expensive,” that fact alone does not require a major market correction. This is because valuations may fall if the rise in stock prices is exceeded by growth in earnings, which reduces the price-to-earnings ratio even if stock prices rise.

These types of soft valuation corrections are typically seen at the start of a recovery when earnings growth is rapid, he said. During this recovery, however, the “compression” of earnings multiples has been slow and uneven, Chadha observed.

Using earnings from the past 12 months, the S&P 500 price / earnings ratio, or P / E, fell from a low of 14 to the depths of Pandemic 27 in early 2021. It then compressed to 23.1, a drop of 14%, as profits outpaced the price hike, but remain 15% above its historic range of 10-20, he noted.

Multiples based on forward earnings estimates moved sideways at a high level. Other ratios, such as enterprise value, or EV, to EBIT (earnings before interest and taxes) and EV / EBITDA (earnings before interest, taxes, depreciation and amortization) are down slightly from at record highs but remain above their tech bubble peaks, Chadha said, while cash flow-based valuations have continued to rise.

Chadha said a “surprisingly rapid rebound” in earnings is the most likely explanation for extreme valuations, noting that S&P 500 earnings have beaten the analyst consensus upward estimate by an unprecedented 15 to 20 percentage points. for five consecutive quarters. But that momentum appears to be on the verge of ending, he said, noting that analyst consensus appears to have caught up, as the pace of gains and upgrades, a key driver of the rise in equities , should slow down.

“At a fundamental level, we believe the main reason the multiples are high is market confusion over our position in the earnings cycle, in part reflecting the speed and surprise with which the economic recovery has unfolded. and the big persistent beats it generated, ”he said. wrote.

And with gross domestic product still well below trend, there is a popular opinion that the best of the recovery is yet to come, Chadha said. The problem is that the sectors of the economy to which S&P 500 companies have the most exposure are already well above the trend, he said, with 2/3 of the S&P 500 industry groups showing levels activity one standard deviation or more above the trend (see graph below).

“So the cycle is much more advanced and the risk is that activity will start to slow down, as the market is valued for most of the recovery to come and the big beats continue,” he said. .