Stocks Are Facing Both Earnings Headwinds and a Compression in the P/E Ratio

These multiples have begun to reverse after a 12-year period where they slowly expanded, in some cases dramatically.

The period after the Great Financial Crisis has not only seen cheap money, it has seen a dramatic expansion of the Fed's balance sheet, now at close to $9 trillion. Netflix is a good example of extreme multiple compression: It is now trading for the same price it traded at in the second quarter of 2020, yet the multiple — the value an investor is willing to put on a future stream of earnings — is much lower today. It is now trading for 34 times 2022 estimates; in 2020, it was trading at 88 times 2020 earnings. Two years prior, the multiple was even higher: 174 times 2018 earnings, according to Factset.

With multiples contracting, and earnings growth much more modest, many strategists are understandably concerned that the market is vulnerable. First, companies are reporting more"normal" earnings beats. In 2021, it was not unusual to see companies reporting earnings 20% above what analysts were expecting.Of the roughly 60 companies that have reported so far, 76% are beating estimates, according to The Earnings Scout. That is high but well below the 88% beat rates from the prior quarter. More importantly, they are beating by only 7.4%, well below the 15% beat rates those companies reported last quarter.

"Actual earnings growth is decelerating and will last at least two more quarters," Nick Raich from The Earnings Scout said in a note to clients last week."Furthermore, our research indicates Fed interest rate hikes are not baked into 2H of 2022 EPS estimates yet either."The pressure on market multiples and earnings is likely to continue.

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