(Bloomberg Businessweek) -- It took inflation hitting highs not seen for decades, and anxiety over the Federal Reserve raising interest rates, but U.S. stocks' valuations had already come down to pre-pandemic, pre-stimulus levels before Russia's Ukraine invasion began. Now Wall Street can't decide what comes next.
While the equity market's response to the war has been muted so far, that may be because investors had been lowering their expectations for two months. The S&P 500 is down almost 8% in 2022, and the technology-heavy Nasdaq-100 is off 13%. Optimists are already making the case that stocks are trading at a discount in an environment where growth is still strong and corporate America's profit machine is still humming. Analysts' earnings estimates for S&P 500 companies haven't wavered from a solidly higher trajectory. “You want to look at those opportunities where some of the bargains have opened up,” says Emily Roland, co-chief investment strategist at John Hancock Investment Management.
But bears have plenty of fodder for worry. Sure, the market has managed to barrel past several seemingly rally-snuffing threats over the past two years—most notably a deadly global pandemic—but it had monetary policymakers firmly on its side. It's different now. The U.S. central bank remains poised to lift interest rates and wrap up its bond-buying program, removing some of the extraordinary support it's been giving asset prices. While it seems increasingly possible the war could slow this process down, it hasn't changed direction. Traders have trimmed bets on a big half-percentage-point hike in March but are still pricing in about five increases in 2022.
The invasion of Ukraine makes inflation, already a worry, even trickier for the Fed to deal with. Up until the end of February, rising prices were seen as mainly the product of hot economic growth, along with tighter labor markets and snarled supply chains. Now international penalties against Russia, a major energy producer, are pushing up commodity prices. While that could be a drag on growth, central banks still may feel the need to raise rates to keep inflation expectations under control. “You have that specter of the late 1970s, early 1980s, of that stagflationary fear of ever-ratcheting-down growth and ever-ratcheting-up inflation,” Alicia Levine, head of equities and capital markets advisory for BNY Mellon Wealth Management, told Bloomberg TV. “And what this conflict does is, it plays into the inflationary piece.”
Stagflation is unlikely—real gross domestic product is forecast to expand 3.7% this year. But the geopolitical situation and its impact on oil prices is highly uncertain. Investors are showing signs of caution. They're buying Treasury securities, which pushes yields down, and stocks in economically defensive sectors such as energy, utilities, and health care. Layer onto all that shaky earnings from some of the big technology companies, and the days of exuberance in every corner of equity markets look numbered. “A broad selloff like this punishes both the guilty and the innocent,” says Michael Shaoul, chief executive officer at Marketfield Asset Management. “This is a market where it's possible to make money,” he adds, but different stocks are going up, and there may be fewer of them.
The price-earnings ratio of stock market benchmarks has become a Rorschach test. Are you looking at a market that's finally reasonably priced again? Or one that's still expensive and has to justify itself each day to investors facing a torrent of bad news? At 22 times annual earnings, the S&P 500's valuation has eased dramatically since hitting 32 a year ago—it's back to where it was in early 2020. But remember, that was at the tail end of the longest bull market in history, before stocks were knocked down briefly by the pandemic. It's a similar story for the Nasdaq-100. It currently fetches 32 times earnings—down from roughly 40 at several points last year, but still well above its historical average.
Whatever comes next, it seems, the speculative fervor that characterized the pandemic-era market—which birthed meme stocks and the boom in special purpose acquisition companies—has cooled off. “The weak-balance-sheet companies, meme stocks, SPACs—those were akin to what we experienced in late 1999, the 2000s,” says Liz Ann Sonders, chief investment strategist at Charles Schwab & Co. “I think the low-quality trade is dead, beyond some of these short-term, counter-trend moves that you might get from traders gambling.” In 2021, it was difficult not to make money—every single sector in the S&P 500 posted double-digit gains. That was only two months ago, but it already feels like a different world. —With Vildana Hajric
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