A reading about 50% historically means the average returns over the coming years will likely be about average. Valuation metrics are not great timing indicators, but looks to frame longer-term expectations and magnitude of a correction when a catalyst develops. Enterprise value (EV) is the amount of debt plus equity capital a company uses less cash like holdings to generate free cash flow. EBITDA and EPS expectations are likely far too high given the tighter financial conditions that are likely to continue for a while longer. The challenge with valuation ratios is that the divisor is a forecast and will change over time.

A reading near 60% historically means the average returns over the coming years will likely be slightly below average. While the market is only modestly expensive historically, this metric suggests longer-term returns will be somewhat less than average and should not be specifically used as a timing indicator, but adds to the cautionary environment. The revenue a company generates is less subject to manipulation (financialization) like earnings per share can be and can be a better valuation metric than comparisons to earnings. Many industries have higher margins, so price-to-sales is not a perfect guide. With several recessionary indicators now fully flashing high risk, decay in the employment picture would cement an earnings recession. With nominal growth still strong, revenue growth is still likely, but margin pressures are building and volumes are already in decline. This should negatively impact EPS going forward.

A reading near 40% historically means we should expect slightly above average return over the coming years. Forward P/Es should not be used as a timing indicator, but rather a guide to current longer term expectations. Earnings expectations are a key factor for longer-term market growth. Forward P/Es historically are 2 multiple points below trailing average. The historic average P/E for US large caps is about 16.5x earnings versus the current forward P/E of 18.08. Over the past 3-months forward EPS estimates have decreased by -0.61%. Over the past month, forward EPS estimates have decreased by -0.32%. The rate of EPS change is declining at a slower place.

A reading near 90% historically means the average returns over the coming years will likely be well below average. While the market is expensive historically, this metric suggests returns will be well below average and should not be used as a timing indicator, but adds to the cautionary environment. The equity risk premium is the discount factor investors are paying for stocks above the risk free rate. The inverse of the P/E called the earnings yield plus the long-term government yield is a reasonable estimate. Overall, the ERP declined 10.2bps last week. The yield of the 30-year bond increased 2.4bps. The earnings yield of the S&P 500 declined 7.8bps. The tightening of financial conditions is likely to continue in the short run. But we are very close to fully pricing in the terminal rate of Fed funds and weakening of the economy and earnings should start to balance out. Markets remain on the expensive side, but it’s mostly because of higher rates.

A reading near 100% suggests the yield curve (3-months vs. 10-years) is forecasting recession within the next 12 months. An inverted yield curve leads to credit contraction as lending profitability is curtailed. A curve this flat suggests financial conditions are extremely tight. The recent trend has been flatter. Last week, the 3M-10Y curve was 28.5bps flatter. The forward curve is pricing in only modest rate cuts by mid 2023. Powell launched the higher for longer narrative and we expect the curve to remain in recession mode until inflation clearly breaks. This restrictive curve could last into 2024, though the recent banking insolvencies can complicate the FOMCs job fighting inflation.

At a reading near 80%, credit spreads are at very wide levels and suggest tight financial conditions and some economic risks ahead. At some point, the worst case is priced in, but this is never a moment in time, but a process over weeks or months. Wide credit spreads correlate with high business cycle risk. If we start to see equities perform better with more bad news, it’s a sign that the worst may be behind us. The yield-to-worst (maturity) for junk bonds is 8.98%, which is -2.1 standard deviations below average. The FOMC and other central banks are reducing liquidity, but big picture it is still ample. Looking out, we should expect tighter financial conditions and wider credit spreads. Over the past month, HY-IG spreads are 65bps wider. Over the past 3 months, HY-IG spreads are 45bps wider. Momentum is increasing.

Over the past week, the NY Fed weekly leading economic index increased. The trend over the past month is rising at a slower pace. The recent trend suggests evidence of modest contraction. Growth challenges are significant without deficit driven stimulus. For more details see: https://www.newyorkfed.org/research/policy/weekly-economic-index#/interactive
We are now past the stimulative phase of the cycle and looking ahead, quantitative tightening (QT) will likely provide a major hedwind for risk premiums. The labour market remains the stickiest part of the core inflation push with real assets showing signs of deflation.

Over the past week, real 10-Year Treasury yields declined -11.3bps. Nominal yields decreased -5.2bps, while long-term inflation expectations rose 6.1bps to 2.55%. Real monetary policy is tight relative to long-term expectations. Short-term inflation numbers remain extremely elevated, while longer-term market based inflation expectations are elevated relative to the range of the past decade. Based on recent curve moves, the market has likely priced in more tightening than the FOMC actually will need to do given increasing odds of a recession.