The recent selloff in the stock market has left investors worried about the sustainability of a rally. Last week, the S&P 500 index dropped 2.5%, the Nasdaq Composite declined 2.6%, and the Dow Jones Industrial Average fell 2.1%. As both the S&P 500 and Nasdaq enter correction territory with a decline of 10% or more from their earlier highs, it's clear that the market is struggling to find stability.
Attempts to rally have been made by the S&P 500 several times in the last few months, but all have fallen short. Even though some of these mini-rallies lasted weeks, they always ended at lower levels than before. This recurring pattern indicates a lack of confidence in the economy, earnings, and the true value of stocks.
According to Jay Woods, chief global strategist at Freedom Capital Markets, sentiment has shifted, and breakdowns are becoming more apparent. This growing skepticism is causing concern among market participants.
Adding to the market's uncertainties is the fact that good news is now perceived as bad news. The US economy showed robust growth of 4.9% in the third quarter before accounting for inflation. While this might initially seem positive, it reinforces the Federal Reserve's determination to maintain high-interest rates as a means to control both economic growth and inflation. Although a rate hike is not expected, investors will be closely watching the central bank's meeting this coming Tuesday and Wednesday for any hints about the future trajectory of interest rates.
The Impact of Higher Rates on the Economy and Investor Confidence
It's no surprise that higher interest rates have significant implications. As rates continue to rise, we can expect economic and profit growth to slow down. This tightening of policy takes time to affect the economy, leading investors and companies to question even positive news related to corporate earnings.
One such example is Meta Platforms (ticker: META), which recently issued a warning during its third-quarter earnings call. Despite easily surpassing forecasts for earnings and sales, the company cautioned that advertising sales could potentially slow down. As a result, the stock experienced a 3.7% drop.
Meta is not alone in experiencing this underwhelming response to strong sales and earnings. According to Evercore ISI, S&P 500 companies that beat estimates in the third quarter only saw an average gain of 0.5% after their reports. This is only half of the five-year average of 1%. These lackluster market reactions are indicative of a market that remains overvalued.
Currently, the S&P 500 is trading at around 17 times the expected earnings per share over the next 12 months. This elevated valuation becomes concerning when you consider that higher yields diminish the value of future profits, ultimately impacting valuation multiples. Based on historical data from Evercore, when the 10-year yield is as high as its current level of 4.84%, the S&P 500's multiple should ideally land in the low teens.
According to Steve Sosnick, the chief strategist at Interactive Brokers, it appears that the yield will remain elevated in the short term. As a result, investors should brace themselves for these conditions. While reaching new highs may be unlikely, it is still preferable to witnessing new lows in the market.