Inside Markets — Equity Multiples

It’s otherwise quiet into tomorrow’s Fed decision with OIS markets still pricing in a pause, while the probability for another ’23 hike (November 1 or December 13) increased to 45% from 40% overnight. Accompanying the pause, consensus expects a hard-nosed ‘higher for longer’ message from Powell and an unchanged median ’23 dot that leaves room for another hike.

We remain tactically bearish as developed markets form distribution patterns amid rising yields and rising crude prices.  As we noted last week, the US yield curve has been inverted for more than 15 months.  In the past, recession-driven bear markets have started 19-24 months after the initial curve inversion. We keep a bearish bias into technical support near 4310.  A break below ~4300 would likely result in rising realized volatility and a break below prior range resistance at ~4200, which would kick off a recession-driven bear market in our view. After a prolonged period of subdued volatility, we’ll take early cues from the CBOE Volatility Index (VIX).  The VIX currently sits at a still-benign level of 15 with levels north of 22 as an early warning.

The S&P 500 has been in an ‘earnings recession’ for the last three quarters. This means the +16.5% year-to-date gain has come from multiple expansion despite a rising cost of capital and restrictive real rates.  Historically, equity multiples contract when the cost of capital and real rates become restrictive. Some of the disconnect has to do with base effects and expectations for a return to earnings growth this quarter.  At current levels, the S&P 500 is trading at ~17x the consensus calendar ’24 EPS estimate of ~$260. Generally speaking, market participants begin using the forward calendar year estimates at the end of Q2. With 10-year real yields closing in on +200bp, the appropriate multiple is closer to 14.3x, which implies a valuation-based S&P target of ~3720.