Stocks are low. Still expensive.

US stocks are off to their worst start to a year in more than half a century. By some measures, it still looks expensive.

Wall Street often uses a company’s share price-earnings ratio as a measuring stick for whether a stock looks cheap or expensive. By this measure, the market as a whole has been extraordinarily expensive for most of the past two years, a period when particularly easy monetary policy has fueled the popular view that low interest rates have given investors few alternatives to stocks.

Despite down 16% to start 2022, the S&P 500 late this week has been trading at 16.8 times its expected earnings over the next 12 months, according to FactSet..

This is still above the average multiplier of 15.7 over the past 20 years, but down from the recent peak of 24.1 in September 2020.

Concerns about inflation and the Fed’s rate hike path have led to the recent turmoil in the markets and sparked a vigorous debate about the appropriate valuations of stocks in today’s environment. The S&P 500’s drop through Friday is the worst performance since 1970, according to market data from Dow Jones.

One source of uncertainty is the growing concern that Fed monetary tightening will push the economy into recession, a scenario in which equity multiples typically fall. Higher interest rates reduce the value of future cash flows for companies in commonly used pricing models. Already, some investors are concerned that market expectations for corporate earnings are too high, given the economic hurdles ahead.

Michael Mulaney, director of global markets research at Boston Partners, which manages $91 billion, said he thinks the S&P 500 is valued somewhat based on today’s rates but expects valuations to fall further.

Stock valuation tends to decline during periods of tightening and earnings growth also tends to slow during these periods, even during periods of time not characterized by high inflation. This means that investors should expect a more austere market environment in the coming months.

What’s more, still early in the Fed cycle, Mr. Mulaney said he expects the central bank will need to raise the benchmark interest rate higher than is currently expected to curb inflation. By the end of the Fed’s campaign, the S&P 500 is expected to trade around 15 times its expected earnings. Add to the recession, and the market valuation is likely to drop to 13 or 14 times earnings, he said.

“We will be in a volatile market until we have some tangible evidence that significant progress has been made in quelling the problem of inflation,” Mulaney said.

Bubble burst?

The market turmoil has drawn comparisons to the bursting of the dotcom bubble in 2000.

Analysts at Citigroup company

He wrote this week that the US stock market entered bubble territory in October 2020 and is now exiting that bubble, although they said stocks are not as stretched as they were during the dotcom era.

The forward multiple rose to 26.2 times earnings in March 2000. In the sell-off that followed, it declined. By 2002, the S&P 500 was trading at 14.2 times next year’s earnings. In 2008, when the country was in a severe recession, this figure reached 8.8.

While few stocks were rescued in this year’s crash, technology and other expensive growth stocks suffered the most. The Russell 1000 Growth Index is down 24% this year, while its peer in value terms is down 8.1%.

Growth Scale members include Apple company ,

whose shares are down 17% this year; Microsoft corp.

, down 22%; Amazon.com company ,

down 32%; and Tesla company ,

down 27%.

S&P 500 stocks, valuation vs. performance

performance, 1 year ago

performance, 1 year ago

performance, 1 year ago

performance, 1 year ago

performance, 1 year ago

By contrast, the measure of value is led by stocks including Berkshire Hathaway company ,

3.8% increase in 2022; Johnson & JohnsonAnd

Increased 3.4% United Health Group company ,

down 3.3%; and ExxonMobil corp.

an increase of 45%.

For example, Tesla shares entered the year trading at 120 times the company’s expected earnings and late this week they were priced at about 54 times, according to FactSet. On the other hand, Exxon Mobil was trading at 10.5 times future earnings at the end of 2021, a multiple that fell to 9.4.

It is normal for stocks in some industries to trade at valuations that are very different from those in other lines of business. Investors are usually willing to pay more for companies they expect will expand more quickly than for those whose growth prospects are limited. Technology stocks often demand rich valuations, while oil and gas companies have historically traded at muted valuations because industry outlooks are subject to supply and demand over energy prices and tend to experience boom-and-bust cycles.

“It’s certainly the more expensive names that have suffered the brunt of the sell-off,” said Mike Stretch, chief investment officer at BMO Wealth Management. “There has been a reset of what is reasonable to pay for valuations in an environment of rising prices.”

US stocks look expensive compared to their overseas counterparts, too. Only benchmarks in Belgium, Portugal and Saudi Arabia, as well as the heavy composite Nasdaq, have higher ratings based on future earnings than the S&P 500, according to data available on FactSet. In comparison, Hong Kong’s Hang Seng is trading with expected earnings of 9.5 times, Japan’s Nikkei 225 is trading at 14.3 times earnings, and Germany’s DAX is trading at 11.4 times.

This disparity has caused some investors to take another look abroad.

“Even in our US-focused strategies, we have good international equity allocations just because they are cheaper,” said Eric Lynch, managing director at asset manager Scharf Investments.

Profit Equation

Prices are just one component of stock valuations. the other? Corporate profits. When profits rise and prices remain constant, valuations shrink. If earnings fall, that makes stocks look more expensive at the same price levels.

So far, earnings have been a rare bright spot in a market shaken by inflation data, leading to a change in Fed policy and headlines around the war in Ukraine and rising Covid-19 cases in China.

With the latest reporting season winding down, analysts expect corporate earnings in the S&P 500 to rise 9.1% in the first quarter of the previous year, versus their forecast of 5.9% growth on Dec. 31, according to FactSet. For the year, earnings are expected to grow 10%, an improvement from the 7.4% growth they forecast at the end of last year.

The strong results are partly due to unusually high profit margins, which indicates that many companies have been able to pass on higher costs to customers through price increases. Analysts estimate that the S&P 500 net profit margin will come in at 12.3% for the first quarter, above the five-year average of 11.2%.

Markets have been looking increasingly shaky lately: stocks, bonds and cryptocurrencies are all plummeting as investors struggle to manage the huge volatility in distressed financial markets around the world. Caitlin McCabe of the Wall Street Journal looks at some of the reasons behind the recent market frenzy. Photo: Spencer Platt/Getty Images

Some investors are skeptical that margins can continue to rise, though.

“It seems unlikely that the peak margins will continue,” said Mr. Lynch, of Scharf Investments. “So even if there isn’t a very large recession, we would still say there is certainly a very reasonable call for margins to shrink, and at least earnings estimates are too high.”

There are other reasons for concern. Companies in this earnings season reported differences in “weak demand” at the highest rate since 2020, according to BofA Global Research.

BofA found that the rise in the 2022 earnings estimate for the S&P 500 is largely due to the bright outlook for the energy sector. Without the sector, which accounts for less than 5% of the S&P 500, expectations for index earnings this year would have been lower than at the end of last year, according to bank analysts.

If earnings disappoint, that would make stock market valuations more expensive than they actually seem — absent another downward move in stock prices.

write to Karen Langley at karen.langley@wsj.com

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