Why Is The Market Going Down?

The economy seems to be doing well, with job growth still at high levels, consumer spending still healthy, and businesses investing. But the stock market—which is supposedly a barometer of that economy—is acting very differently. The market has fallen significantly from its peak at the start of the year and, more recently, has taken a sharper drop. What’s going on here, and will it continue?h5 All About Interest Rates/h5

First of all, the stock market does not directly reflect the economy. There is a link, but what the stock market tracks are two things: corporate earnings and interest rates. Earnings, of course, grow when the economy grows. So when interest rates are reasonably steady, the market does grow with the economy. Since that is most of the time, we think the market tracks the economy.

It has been a difficult couple of months. Most of the time is not all of the time, however. We are now in one of the times when interest rates are not steady. Over the past couple of months, we have seen rates increase at one of the fastest paces in decades. Thus, even as the economy has done well and earnings continue to grow, those higher interest rates have acted as a headwind and pulled the price investors are willing to pay for those earnings down. And with the Fed publicly committed to continued interest rate hikes, the market clearly is pricing in more headwinds going forward.

But that fact also suggests that the future damage is likely to be limited. Markets already expect—and are pricing in—substantially higher rates. Any more damage has to come from interest rates moving even higher than the current substantial anticipated increases. At some point, that will not happen, as the factors driving those higher rates (i.e., growth and inflation) start to roll over.

We are seeing signs that growth is slowing, for example, and there is talk of a recession in the next year or two. Inflation pressures, while still very real, are also starting to weaken. Just as markets are pricing in rate increases over the next year, they are also starting to price in rate decreases after that. Any decreases we see will act as a tailwind for stock prices at that time.

One way to evaluate where we are and where we are going is to look at overall valuation levels, which vary with interest rates. The chart below shows, for example, that between 2016 and 2019, before the pandemic, investors were willing to pay between 16 and 18 times the next year’s expected earnings for the S&P 500. After the start of the pandemic, when interest rates were cut sharply, they jumped up to 20 to 22 times earnings.

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However, since the start of the year, as interest rates rose and the Fed committed to even higher rates, valuations dropped to between 18 and 20 times. That explains much of what has happened so far.

Source: com/pub/peacockfeval.pdf
*Implied stock price index calculated using actual 52-week consensus expected forward earnings times hypothetical forward P/Es. Note: Shaded areas are recessions according to the National Bureau of Economic Research. Source: Standard & Poors and I/B/E/S data by Refinitiv.