Welcome to the weekly market update from Signature Wealth Management. I’m Brian Ransom, Research Director from Signature Wealth and here’s what happened in the market this week.
Following last weeks dreadful returns, the market actually responded positively this week and is up 3.3% from the bottom. The S&P remains well above the Pre-pandemic highs set in early 2020 for the time being.
In the news this week, Federal Reserve chairman Jerome Powell testified before Congress. The US and Europe show signs of slowing economic growth as recession fears increase. And stock futures actually rise because this news. This may sound counter intuitive at first. But for the last 6 months, the market has pulled back because of hot inflation and rising interest rates. A recession would mean cooling inflation and falling interest rates. Thus, the positive move higher.
On that note, the last 6 months have been driven by that theme of rising interest rates and price-to-earnings compression or PE compression. While prices in the stock market have fallen over 20%, shown in blue, the valuation of the stock market or PE shown in purple have been declining for well over a year now. That’s primarily because of rising interest rates. Basically, as interest rates rise, future cash flows must be discounted at a higher rate and the value of an asset falls because of it.
The question remains, how much further can PE’s compress? Well, we can use the 1994 bond crash as a comparison. In 1994, the Federal Reserve gave a surprise interest rate increase that caused the bond market to sell off, increasing interest rates, and causing PE compression throughout the stock market. The 2-year yield began a rapid ascent and PE ratios followed. It wasn’t until the Federal Reserve capitulated to a slowing economy and began cutting interest rates that the stock market valuations began to recover. This happened to coincide with a near inversion of the 10-2 yield curve.
Compare that to today, the 2-year yield is once again rapidly rising in response to the Federal Reserve and PE’s are compressing in conjunction. Likewise, we are currently very close to another 10-2 yield curve inversion as we speak. However, we do not yet know exactly how high the Fed intends to raise interest rates nor do we know exactly how high the 2-year yield will reach.
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1.FactSet Research Systems. (n.d.). S&P 500 (Interactive Charts). Retrieved June 24, 2022, from FactSet Database.
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3.FactSet Research Systems. (n.d.). S&P 500 PE & 2 Year Yield (1994, Interactive Charts). Retrieved June 24, 2022, from FactSet Database.
4.FactSet Research Systems. (n.d.). S&P 500 PE & 2 Year Yield (present day, Interactive Charts). Retrieved June 24, 2022, from FactSet Database
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