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

While stock P/E multiples appear reasonable today, equity market fundamentals have begun to show some signs of weakness.

Fundamentals showing cracks chart illustrationThe 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.

Past performance does not guarantee future results. All investments include risk and have the potential for loss as well as gain.

Data sources for peer group comparisons, returns, and standard statistical data are provided by the sources referenced and are based on data obtained from recognized statistical services or other sources believed to be reliable. However, some or all of the information has not been verified prior to the analysis, and we do not make any representations as to its accuracy or completeness. Any analysis nonfactual in nature constitutes only current opinions, which are subject to change. Benchmarks or indices are included for information purposes only to reflect the current market environment; no index is a directly tradable investment. There may be instances when consultant opinions regarding any fundamental or quantitative analysis may not agree.

Plante Moran Financial Advisors (PMFA) publishes this update to convey general information about market conditions and not for the purpose of providing investment advice. Investment in any of the companies or sectors mentioned herein may not be appropriate for you. You should consult a representative from PMFA for investment advice regarding your own situation.

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