It’s not just China Evergrande. Why the S&P 500 is crashing and what to do

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The stock market is crashing and a correction may be in sight. While China Evergrande is getting all the attention, the real issue could be the risks to earnings and valuations.

The

S&P 500
fell 1.7% on Monday. Although the decline is bad, the index is only down 3.9% from its all-time high. This may be just the start, says Barry Bannister, chief equity strategist at Stifel, who is calling for the S&P 500 to drop as much as 15% this year. “It’s the merging of several risks in the fourth quarter that causes us to be cautious in September and October,” Bannister said.

With Evergrande grabbing the headlines, the biggest problem right now could be US earnings. S&P 500 companies are expected to earn $ 217.95 in 2022, up 9.4% from 2021, but there are plenty of downside risks. Supply chain constraints hamper the ability of companies to meet sales expectations, while costs continue to rise. From companies from industrial materials maker PPG Industries (PPG) to home builder

Pulte Group

(PHM), have announced that sales and profits for 2021 will fall short of expectations. Investors will have a clearer picture of the supply chain problem when companies release their quarterly earnings this fall.

“One question that will start to arise once we get into the third quarter is to what extent supply chain disruptions and inability to meet demand will affect business results,” said Yung Yu Ma, chief investment strategist at BMO Capital Markets. . “It is getting a lot sharper.”

The other risk to profits that the markets have largely ignored is rising corporate taxes. Goldman Sachs strategists say 2022 earnings per share on the S&P 500 could drop about 5% with a corporate tax increase to 25% from the current 21% – and House Democrats have recently proposed an increase to 26.5%. With aggregate analysts’ estimates for 2022 for the S&P 500’s EPS at $ 217.95, therefore, EPS could drop to $ 207. At 21 times currently, the index could drop 5% if there is a corporate tax hike, assuming the multiple of future earnings stays the same.

Chances are not. One of the main reasons the average valuation of the S&P 500 is above its pre-pandemic level of 19 times – it is currently trading at 20.4 times 12-month futures earnings – is that the 10-year Treasury yield fell to 1.31% from 1.8% just before the pandemic – and lower bond yields make future earnings more valuable.

There is a good chance that the yields will increase. The Federal Reserve recently bought tens of billions of dollars in treasury bonds per month, pushing bond prices up and yields lower. But the central bank is now signaling that it will cut that program as early as this year to zero dollars within a few quarters, which means less money in bonds, lower prices and higher yields (more on Wednesday). when the Fed releases its monetary policy statement). This catalyst could take the 10-year Treasury yield to 1.8% by the end of the year and the S&P 500 multiple to 19 times, writes Mike Wilson, chief US equity strategist at Morgan Stanley.

Combine the lower valuations with lower earnings estimates and the S&P 500 may still have a lot to go down. If the index trades at 19 times 2022 earnings of $ 207, the S&P 500 would trade at 3,914, about 10% below its current level. If BPA is lower than that due to supply chain issues, the market could drop even more. Wilson’s worst-case estimate for the index is 3,700 in June, down 15%.

This means there is still time for investors to play defense. Part of a potential correction would be driven by fears of slower economic growth, meaning investors should hold stocks whose earnings streams are less sensitive to changes in economic demand, such as goods. consumer staples, health care, utilities, real estate and telecommunications. History confirms it: When the S&P 500 drops 10%, going back to 1990, these five sectors are returning around 1% on average, according to Stifel’s Bannister. “Defenses are a good place to hide if you’re in a risk meltdown in September or October,” Bannister explains.

Of course, there is another place investors can hide: cash. Not only does cash allow investors to top up on stocks when they plunge, but if stock and treasury prices fall, cash will hold its value except for the impact of inflation. “Sometimes the less attractive asset is the best,” says Bannister.

Sometimes it’s better to be safe than sorry.

Write to Jacob Sonenshine at [email protected]