Weekly Indices Review - 7 September

Macro overview

Welcome to the first of our new weekly reviews of major equity indices. We will help you by focusing on the major macro story affecting the global equity markets. As this is the first of these weekly reviews, we have taken a long-term perspective on the broadest of indices:  the US S&P 500.

The dominant focus for equity markets is inflation and earnings compression. To forecast the present value of equities investors “simply” forecast expected future earnings and then calculate the present value of these expected earnings using an estimated interest rate.

Investors require good future earnings estimates and solid future interest rate expectations to create the most reliable current price estimates. For much of the past decade it was fairly straightforward to obtain both.

However, through H1 2022, inflation expectations shifted the future expectations of interest rates. Higher interest rates meant the present value of expected future earnings would be less, causing lower equity prices through H1.

The concern now is if we will see earnings compression in Q3-Q4. If this side of the formula also needs to be lowered there could yet be another serious leg lower in equity prices in the months ahead.

Currently, the consensus estimates on US equities signals a significant fall in earnings - this view will need to hold. Many analysts are concerned this consensus may be too lofty, given the ongoing pandemic lockdowns in China, widespread supply chain issues, record levels of inflation, the cost of living crisis, and geopolitical concerns around Ukraine and potentially even Taiwan.

This leaves a tentative picture for equity markets as we move closer to the end of Q3.

Technical picture

This monthly chart clearly shows how the US S&P 500 has powered higher since the start of the new millennium.

The crash from the dot com bubble-induced highs into the end of 1999 can be seen, as can the sell-off related to the global financial crisis of 2008. From these lows of under 800 in 2009, the US S&P 500 has over the next 13 years powered higher to the recent all-time highs of above 4800. Over this timescale, and on a semi-log scale, the moves lower in H1 2022 appear relatively minor, and the index remains in an extremely strong long-term trend.

Can the market push lower if inflation concerns persist? Based on this timescale, yes. As falls towards 3000 or even 2300 would still “only” be a minor retracement of this extremely powerful move. Some analysts remain concerned that much of the surge from 2008 has been directly as a result of the increase to the US money supply, after the huge QE by the Fed both back in 2008-2009 and again more recently with pandemic stimulus.

Glass half-full or half-empty?

It is always useful to take a step back now and then to take in the big picture. The falls so far in 2022 have in the grand scheme of things been relatively minor, and prices could yet fall quite considerably further if the inflation story continues to evade the actions of the central banks.

Alternatively, the strong action by the Fed, which has now largely been priced in, may be enough to contain inflation. In this case, current deflated levels could prove to be excellent long-term entry levels.

So, there are two ways to look at this: glass half-full, which is that inflation will be contained and current levels remain attractive; or glass half-empty, which is that the Fed acted too late on inflation and QE stimulus since 2008 has pushed indexes unsustainably high.