asset allocation | august 23, 2022
A Fall in Earnings Estimates Could Worsen Sell-Off
Attractive stock prices are based on optimistic earnings estimates.
Rising recession concerns have exacerbated the stock market sell-off, and major indexes are now in or near bear market territory.
Given optimistic forward earnings estimates, we believe that current stock prices may not have fully baked in a recessionary scenario.
Tim Murray, CFA
Capital Markets Strategist, Multi‑Asset Division
Deepening recession concerns have caused stocks to sell off precipitously in 2022, and major indexes recently reached bear market territory—meaning that they had fallen at least 20% from their recent highs. An in‑depth look at the sell‑off reveals that it has primarily been driven by a decrease in price‑to‑earnings (P/E) multiples (Figure 1).
Although some investors may conclude that stock valuations have now become reasonable, it is important to note that, despite numerous signs of looming economic weakness, earnings estimates have not adjusted downward this year. So far in 2022, the consensus 12‑month forward earnings-per-share (EPS) estimates have, in fact, risen by 4%. Therefore, while the current P/E ratio seems attractive, it is based on a very optimistic outlook for company earnings.
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Anatomy of the 2022 Sell‑Off
(Fig. 1) The price‑to‑earnings (P/E) ratio of the S&P 500 has declined, but forward earnings estimates remain overly optimistic
January 1, 2019, to July 18, 2022.
Past performance is not a reliable indicator of future performance.
Source: S&P. T. Rowe Price analysis using data from FactSet Research Systems Inc. All rights reserved. See Additional Disclosures. Bloomberg Finance, L.P.
Actual outcomes may differ materially from estimates. Estimates are subject to change.
For investors evaluating the current market environment, a review of historical data showing how earnings estimates have behaved during past recessions can be informative. Notably, an analysis of consensus earnings estimates for companies listed on the S&P 500 Index since 1990 shows that during each of the past four recessions, earnings estimates fell sharply, with an average drop of 22% (Figure 2).
Overall, stock prices seem more reasonably priced relative to their peaks early in the year. However, in our view, a recessionary scenario may not be fully baked in to the current share prices because earnings expectations remain too optimistic. As a result, our outlook remains cautious, and our Asset Allocation Committee has maintained an underweight allocation to stocks relative to bonds.
How Far Could Earnings Estimates Fall?
(Fig. 2) Earnings estimates have fallen meaningfully during past recessions
January 1990 to June 2022.
Sources: T. Rowe Price analysis using data from FactSet Research Systems Inc. All rights reserved. See Additional Disclosures. Bloomberg Finance, L.P.
Actual outcomes may differ materially from estimates. Estimates are subject to change. Past occurrences are not a reliable indicator of future occurrences.
*Recessionary periods are defined by the National Bureau of Economic Research (NBER).
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The views contained herein are those of the authors as of August 2022 and are subject to change without notice; these views may differ from those of other T. Rowe Price associates.
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