The Fed’s stern message adds to concerns about stock valuations

The prospect of faster-than-expected monetary tightening has rocked Wall Street, dragging the S&P 500 deeper into bear territory on Tuesday and forcing investors to reevaluate a stock market that doesn’t look cheap even after its dramatic sell-off.

It’s been an ugly spell in markets, reflecting concerns about how the economy will hold up when the Federal Reserve launches its harshest campaign of rate hikes in decades. Investors are expecting a 0.75 percentage point rise on Wednesday, which would be the largest since 1994.

Stocks were marginally mixed on Tuesday, with the Dow Jones Industrial Average falling 152 points, or 0.5%, and the Nasdaq Composite Index rising 0.2%. The Nasdaq and S&P 500 are in a bear market, defined as a decline of at least 20% from their highs.

Many investors are claiming that the worst in the markets could be over soon given the continued declines in many market sectors this year and the generally healthy state of the US economy. They say buying the dip fell out of favor during this year’s loss, but this negative sentiment is often a harbinger of an extended recovery.

But even many optimists in equity markets acknowledge that a recovery would face some significant obstacles, chief among them persistently high valuations, which tends to be one of the strongest factors in predicting market developments over time. Even with the S&P 500 down 22% in 2022, many investors and analysts worry that stock market valuations must continue to fall. The S&P 500 on Monday traded at 15.8 times its forecast earnings for the next 12 months, according to FactSet, still above the 15-year moving average of 15.7.

A hike in interest rates by a larger 0.75 percentage point, or 75 basis points, on Wednesday could be a way for the Fed to catch up on a rise in inflation that was far higher and more persistent than officials expected. Evidence of rising long-term inflation expectations by firms and households would be particularly alarming within the central bank.

“I get the impression that the Fed decided to use 75 basis points instead of 50 because the data we’ve had over the past week or so shows higher inflation and perhaps even more worrying news about inflation expectations,” formerly New York Fed President William Dudley said Tuesday at an event hosted by the Wall Street Journal’s CFO Network.

Mr Dudley said the same arguments for a 0.75 percentage point hike could be used to argue for a one percentage point hike “because when you decide the speed at which you get there is just as important as the level you’re going to reach, why don’t you get there quicker?”

But he said he expects officials to “probably split the difference” by opting for the 0.75 percentage point move instead.

Analysts who closely analyze central bank policy were divided Tuesday on whether the potential costs outweighed the benefits of switching to a more aggressive 0.75 percentage point rate hike versus the half-point hike expected ahead of the latest inflation reports.

The Dow Jones Industrial Average fell 0.5% on Tuesday, while the Nasdaq Composite rose 0.2%. Some fear the Fed’s tightening could push the economy into recession.


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Some warned that by recently issuing unusually specific instructions that it would raise interest rates by half a percentage point this week, the central bank risks creating even more confusion in financial markets. Krishna Guha, vice chairman of Evercore ISI, said in a note to clients on Tuesday that he was concerned that the 0.75 point rate hike “is not embedded in a credible and systematic policy strategy and without it will look like a panicked response.” could… that can’t age well.”

Mr Guha, a former adviser to the New York Fed, said such a move created a “serious problem tomorrow morning” by raising hard-to-answer questions about what the Fed would do next.

Economists at Deutsche Bank said they expected the Fed to hike rates again by 0.75 points at their July meeting, which would put the Fed on track to raise rates much closer to the levels suggested aims to actively slow down the economy by the end of this year.

The Fed’s campaign to tame inflation is turning on its head the dynamics that have dominated the stock market in recent years, as interest rates at rock bottom prompted investors to seek yield in risky assets. The widespread perception that there are no alternatives to stocks helped propel the S&P 500 higher, reaching a valuation high of 24.1 times its forecast earnings in September 2020.

More recently, inflation concerns and the path of interest rate hikes have caused turbulence in markets and heated debates about the right valuation of equities in the current environment. One cause for concern is the risk that Fed tightening could push the economy into recession, damaging both corporate fundamentals and investor sentiment. Higher interest rates directly reduce the value of companies’ future cash flows in commonly used pricing models.

A concern for financial markets is that bond investors are beginning to anticipate not only a stronger trajectory, but also a higher target or so-called terminal rate for the Fed. On Tuesday, investors in the interest rate futures market rated a nearly 89% probability that the Fed would hike rates to around 4% or higher by June 2023. That market implied probability was 1% four weeks ago, according to CME Group.

During tough times, investors can quickly decide that stocks are worth a lot less. And historically, valuations have continued to fall before bottoming out. In the December 2018 sell-off, during the Fed’s last prior tightening cycle, the S&P 500 forward multiple fell as low as 13.8. In the depths of the March 2020 sell-off, when the arrival of the Covid-19 pandemic shut down much of the economy, the index was trading at just 13.4 times its forecast gains.

“Markets don’t typically bottom near historical medians,” said Greg Swenson, portfolio manager at Leuthold Group. “From a valuation perspective, they tend to overshoot on the downside.”

Additional Concerns for Stock Investors: Many have begun to worry that corporate earnings are under threat, suggesting that valuation measures based on earnings forecasts may underestimate how expensive stocks really are. US companies have warned of challenges on multiple fronts, from rising costs to an exchange rate collapse from a stronger dollar.

“These valuation multiples are based on a really optimistic earnings outlook,” said Mr. Swenson.

Another valuation model, the Buffett Indicator, compares the value of publicly traded companies in the US to the country’s gross national product. Late last week, one version of this metric was 29% above its historical average and above its peak in the days of the dot-com bubble in 2000, suggesting the market is overvalued. The metric is named after Warren Buffett, who once called the indicator “probably the best single measure of where.” [stock market] Ratings are available at any given time.”

Two recent surveys have shown signs that consumers’ long-term inflation expectations are rising. Fed officials said they would want to react aggressively to signs that such expectations are rising or “anchoring” because they believe the process of wringing inflation out of the economy will become much more difficult once that has happened.

These moves “are more in line with … our own view that tightening policies are necessary to tame inflation,” wrote Matthew Luzzetti, chief US economist at Deutsche Bank. “Such a move will also help bolster the Fed’s credibility that monetary policy stance will quickly adjust to a new reality of persistently elevated inflation.”

Write to Karen Langley at karen.langley@wsj.com and Nick Timiraos at Nick.Timiraos@wsj.com

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