This article was written exclusively for Investing.com
The stock market of today and the late 1990s have so many similarities that it can be, at times, rather scary. The data is just sitting there for all to see, and what it suggests is that this current stock market needs to go through a significant period of multiple-contraction.
Earnings growth rates are forecast to fall dramatically next year, and in the past, when growth rates fell, so too did the earnings multiples. Should that happen, it is likely to lead to, at best, a range-bound stock market. If it turns out to be the case that earnings estimates are falling too, then the stock market is likely to follow those earnings estimate trends lower.
End of the Cycle
The path of the S&P 500 on an 18-month forward PE basis is relatively similar, if not nearly identical, to that of 1998 through 2002. Based on this analog, the S&P 500 of today is at the midway point of its lifecycle. Meaning we are now at the apex of multiple expansion. The next phase of the cycle should lead to the PE multiple for the S&P 500 to contract or fall.
Growth Rates Are Falling
It isn't just the lifecycle that is likely to cause the PE multiple to drop. The trend in earnings growth forecast for the year 2001 shows that once the growth rate began to slip in the fall of 2000, the PE multiple on the S&P 500 began to contract rapidly. It fell from around 23 to a low of almost 14 by the summer of 2002. It wasn't until growth trends for 2003 began to rise that the S&P 500's multiple began to expand once again.
The Analog
It may be way too early in the cycle to have a solid conclusion, but given the trends already being observed, it may be worth exploring the possibility that the growth rate of 2022 follows a similar path as 2001. The growth rate for earnings in the S&P 500 in 2022 has slipped rather dramatically in recent weeks, falling from around 17% to roughly 12% today. Additionally, given that historically analysts' consensus estimates start high and come down over time, if that same scenario plays out, then the growth rate for 2022 may continue to slip. Should that happen, one could expect to see the PE multiple of the S&P 500 continue to trend lower as well, just as it did in 2000 and 2001.
Estimate Trends
The other piece of the equation here is the trend in earnings estimates themselves. Rising earnings estimates lead to a higher value for the S&P 500 while falling estimates lead to lower values. The earnings estimates for 2021 and 2022 have consistently increased in recent months. However, there seems to be an indication that the rate of change may be slowing. After the big move higher in 2022 estimates in April and the first week of May, estimate changes have slowed dramatically. It could be due to analysts waiting for earnings season to begin the next upgrade cycle, or the upgrade cycle may be near the end.
Interestingly, the earnings trends for 2021 and 2022 are following a similar path to those of 2004 and 2005. If that is the case, the S&P 500 is likely to, as noted previously, trade at the very least sideways in the months ahead. As 2004 and 2005 earnings trends flattened out, so too did the advance of the S&P 500 at that point in time.
It seems that from a few perspectives, unless the S&P 500 can maintain its high PE multiple, growth rate, and current earnings trends, the index is at best likely to be range-bound for a while as the PE ratio contracts to account for slower growth next year. How bad it gets will entirely depend on whether or not earnings trends begin to deteriorate as well.