As greater evidence of an economic slowdown emerges, how have stock market fundamentals been affected?

The repricing of equities last year took a significant degree of valuation froth out of the market, pulling S&P 500 Price/Earning (P/E) multiples back down in line with their 25-year average. More reasonable valuations have certainly improved the outlook for long-term performance, but they tend to be a poor predictor of short-term market moves. With earnings growth rolling over and growing questions about the economy’s continued runway for growth, the outlook over the coming year remains uncertain.

The chart above illustrates the history of profit margins and earnings expectations for the S&P 500 since 2005. The two measures began to roll over last year as spiking inflation, an acute labor shortage, and a spike in interest rates materially increased financing and input costs for businesses. Pressures also weighed on top-line revenue as consumer purchasing power eroded and the momentum from the post-recession spending binge dissipated. Consequently, profit margins and earnings have started to pull back, although both remain solidly above pre-pandemic levels. Some degree of weakness appears to have been priced into equity markets today. If the economy softens in the latter half of the year as consensus forecasts suggest, further downside in profit margins and earnings would be expected.

Whether the economy can ease to a soft landing remains to be seen, but a convergence of questions related to inflation, interest rates, and tighter credit lingers, along with elevated geopolitical tensions. As always, the potential for additional volatility remains a risk for stocks. Nevertheless, reasonable equity valuations today should provide some support. Additional easing in inflation should in due time also allow the Fed to ease rates — a development that could change the valuation picture for equities from reasonable to attractive.