The environment for US stocks in 2022: high inflation, rapid upward interest rates on US debt and a decline in EPS growth year-on-year, the general environment is not conducive to US stocks. Since 1965, a total of 5 years have met the following conditions: 1. The EPS growth rate of the current year has decreased compared with the previous year; 2, the INTEREST rate of US Treasuries has risen; 3, the growth rate of CPI has expanded compared with the previous year. These 5 years of U.S. and Chinese stocks tend to have poor annual earnings, and 2022 may be the sixth year. Judging from the performance of US stocks in 5 similar years, the annual adjustment of about 15% may mostly reflect the current known bearish factors. In the future, the US stock market will further break down sharply, and further deleveraging events or recession concerns will be needed to promote it.
The correlation between the CSI 300 trend and the CSI 300 growth/value stock ratio and the US Treasury interest rate is significantly higher than that with the China Bond. At the same time, the trend of the CSI 300 is highly synchronized with the balance sheets of the four major overseas central banks year-on-year, and we have calculated the time when the downward adjustment of the CSI 300 Index turned into a shock based on the current balance sheet reduction information.
Since 2022, the US CPI has continued to refresh the 40-year high point year-on-year, and the CPI reached a new high of 8.5% in March. Meanwhile, U.S. Treasury yields have soared, with U.S. Treasury yields rising rapidly after mid-March, with the 10-year Treasury yield rising from a low of 1.66% on March 7 to 2.83% – hitting long-term downside resistance. After mid-March, U.S. and Hong Kong stocks launched a round of short-term rally under the influence of the marginal easing of the Russo-Ukrainian war and the influence of fund rebalancing, which has recently retreated, but is still higher than the March low. In the context of high inflation and rising interest rates, can the US stock market buck the trend again in the future? In this article, we will analyze the influencing factors of US stocks and analyze the future trend of US stocks and the impact on A shares with reference to similar stages in history.
First, the theoretical analysis of the influencing factors of stock prices
Among the various valuation models, the PE method simply and effectively divides the stock price into two variables, EPS and PE, which are also the determinants of the stock price.
According to the DDM dividend model, the stock price is the sum of the discounts of dividends in each period, and when we assume that the company can continue to operate and the company's profits grow at a sustainable growth rate, the stock price is approximately equal to the product of the expected dividend (the product of EPS and dividend rate) and the discount rate. Discount rates are correlated with risk-free rates, which can be approximated in terms of ten-year Treasury yields, and equity premiums, which are the market's sensitivity to equity risk. When we assume that investors' sensitivity to stock risk remains unchanged and the dividend rate remains unchanged, the risk-free interest rate of the market will rise, and the discount rate will decline, resulting in a decline in PE, which in turn will affect the stock price. This is the first transmission mechanism that affects stock prices – the risk-free interest rate.
Since the nominal risk-free interest rate is the sum of the actual risk-free interest rate and the inflation rate, the inflation rate also has an impact on the stock price, and when the market is in high inflation, the nominal risk-free interest rate increases and the discount rate decreases, which in turn affects pee and stock prices.
The risk-free interest rate mainly affects the stock price by affecting PE, and the stock price can be expressed as the product of two variables, EPS and PE, so the company's profitability EPS is the second key factor affecting the stock price, and when the company's EPS falls, the stock price will also be constrained.
In March 2022, the US CPI has reached 8.5% year-on-year, the 10-year US Treasury yield has also risen rapidly by more than 1% in March, and the corporate EPS has dropped from 38% in December 2021 to 26% in March 2022, and the macro environment is not conducive to US stocks. In the next section, we will take the history as a mirror and discuss the impact of these factors on the S&P 500 index.
Second, take history as a mirror - historical analysis of stock price impact indicators
Based on the analysis in the first section, we have counted the relationship between S&P 500 earnings and 10-year Treasury yields, CPI, and S&P 500EPS since 1965.
2.1 Us Treasury 10-year yield
For the risk-free rate, we use the 10-year Treasury yield approximation as the proxy variable. The 10-year Treasury yield has continued to decline since peaking at 15.41% in the 1970s and 1980s, and has remained below 4% after 2010.
Since 1965, the full-time correlation coefficient between the 10-year Treasury yield and the S&P 500 has been 0.12. However, the correlation between the two was significantly differentiated around 2000, with a correlation coefficient of -0.44 before 2000 and a correlation coefficient of 0.51 after 2000. The structural downturn in the 10-year US Treasury yield center after 2000 and the steady recovery of US corporate earnings have boosted the rise of US stocks and US Treasuries, and the dividend rate of US stocks after 2000 exceeded that of the real interest rate of US Treasuries in ten years is also an important reason for the simultaneous rise of the two. Now that global inflation is at a 40-year high, U.S. Treasury yields may have ended a 40-year downward trend, and U.S. stock earnings may have structurally peaked (globalization has contributed more than 50% of U.S. stock profit growth over the past 20 years), and U.S. stock and Treasury yields may turn negative again. At present, the global interest rate resonance is in the ascendant, and further upward interest rates will suppress the valuation of US stocks.
We count the rates of change in the 10-year Treasury yield since 1965 (expressed by the zscore normalization of the 10-year Treasury yield change bps per month compared to the data of the past 3 years). The results show that when the 10-year Treasury yield rises rapidly and the value of the change exceeds the 2 standard deviation of the past 3 years, the S&P 500 index tends to record negative returns in the coming month. Between 1965 and 1981, the 10-year Treasury yield rose by 11.31%, during which 10 months of yield change exceeded the 2 standard deviation of the past 3 years, and then the US stock market performed poorly at that time. The march 2022 10-year Treasury yield was the fastest in two decades, with a zscore-adjusted change of 2.93 in March 2022, at the 99.4% quantile since 1965. At present, with the rapid rise of the US Treasury interest rate, from the perspective of nominal interest rates, the us stock price is already lower than that of the US Treasury. The future rise in real interest rates in the tide of tightening will further reduce the advantage of holding US stocks relative to US bonds.
2.2 CPI YoY
In the 1970s and 1980s, the U.S. CPI remained above 10% year-on-year, reaching a peak of 14.8%. Before this round of inflation recovery, US inflation remained below 6% for nearly two decades. Even in the post-2000 commodity investment cycle, CPI was smoothed out year-over-year due to factors such as globalization [1]. After 2020, due to the end of the commodity mining cycle, the excess liquidity of the US dollar, the bottleneck of the supply chain under the influence of the epidemic, the lower production limit of the carbon peak target, and the conflict between Russia and Ukraine, global inflation entered a structural recovery stage. The U.S. CPI rose to 8.5 percent year-over-year in March 2022, surpassing the highest level in nearly four decades during the oil crisis of the 1990s.
CPI year-on-year mainly affects pee and then affects stock prices by affecting the discount rate, and the negative correlation between CPI year-on-year and S&P 500 year-on-year since 1965 is -0.38. The increase in CPI pushed up the nominal risk-free rate and the stock discount rate fell, which in turn depressed the performance of PE and US stocks. Similar to U.S. Treasury yields, the sharp year-on-year upswing of CPI generally corresponds to the period of poor performance of the S&P 500, such as the 1970s and 1980s, and this round of CPI upwards has contributed to a significant adjustment in U.S. stocks (especially high-valued stocks represented by ARKK).
The year-on-year correlation between the U.S. CPI and the S&P 500 also diverged around 2000. The correlation coefficient between the two before 2000 was -0.39, and the local maximum value of the CPI year-on-year basically corresponded to the local minimum value of the S&P 500 index year-on-year; after 2000, the macroeconomic fluctuations decreased, and the moderate CPI growth rate was accompanied by the growth of US stock earnings, and the correlation coefficient between the two became 0.25, and the positive correlation after 2015 was more significant. But as the CPI pivot enters a period of structural recovery, the correlation between the CPI and the S&P 500 may turn negative again.
2.3 S&P 500 EPS YoY
Investors are concerned about the company's future development prospects, and EPS represents the profitability of the company, so it is a matter of concern. Since 1965, the EPS growth rate of the S&P 500 has shown cyclical fluctuations, and in the period of high inflation around 1980, the oil crisis in the early 1990s, the Internet bubble period around 2000, the subprime mortgage crisis in 2008 and the epidemic period in 2020, corporate profitability has been significantly impacted, and the EPS growth rate of S&P 500 has turned negative in stages. After the COVID-19 pandemic, due to the low base effect and loose monetary policy, the EPS growth rate of the S&P 500 began to pick up, and the EPS rose from -32% in December 2020 to 110% in December 2021. However, since then, due to the high CPI in the United States, the energy crisis and the collective rise in the price of all categories such as food wages and rents, the growth rate of S&P 500EPS has begun to decline under the influence of global inflation.
Since 1965, there has been a clear positive correlation between the EPS growth rate of the S&P 500 and the S&P 500 year-on-year, and when the EPS increases rapidly, corporate profitability is high, the US stock market is strong, and vice versa. The correlation coefficient of the two is 0.21 in the whole period, and after 2000, the two movements are almost exactly synchronized, while the correlation coefficient rises to 0.40. This may be because before 2000, the macroeconomic fluctuations were greater, and the PE reflected in inflation and ten-year bond yields had a larger weight on the stock price; while after 2000, the macroeconomic fluctuations fell, and the risk-free interest rate and inflation level remained in the low range, at this time, the company's profitability and development prospects were weighted, and the EPS impact on the stock price was more obvious. At the same time, there is a high synchronization between the changes in the growth rate of US stock EPS and the changes in the US economic cycle and inventory cycle, and the eps decline is most significant in the active destocking stage.
EPS can be further broken down into net interest rate, operating income and number of shares of common stock, and there is a high correlation between net interest rate and corporate EPS. Historically, high inflation has depressed the profit margins of U.S. stocks. During the period of persistently high inflation from 1965 to 1985, U.S. stock profit margins continued to decline. The main factor that dragged down profit margins during this period was the cost of the product, which was increasing in the company's ability to transfer costs to customers. High interest rates also increase interest expense expense. An important reason for the increase in U.S. stock gross margin in 2021 is that companies have cleared the inventory with lower costs of pre-epidemic production, and as the sales of original products, the cost of new products continue to rise, and related costs are difficult to transfer to consumers, the impact of high inflation on S&P 500 profit margins and EPS has begun to appear, bringing about adjustments in U.S. stocks since the beginning of the year, and may bring further pressure. At the same time, risk-free rates continue to rise at any time, and interest expenses increase, which will also erode net interest rates.
At present, the median analyst expectation shows that the gross margin of the 2022Q1 S&P 500 decreased by 0.3% month-on-month, and the profit of the financial industry and technology industry fell sharply in the quarter, while the profit margins of industries such as real estate, healthcare, energy and materials are expected to increase, and the growth rate of US stock EPS and US industry-wide gross margin has begun to slow down.
3. Prospects for the future market
From the above indicator decomposition, it can be seen that risk-free interest rates, inflation and EPS growth rates are not conducive to future US stock performance. However, it is undeniable that some of these bearish factors must have been reflected in the current price. This suggests that once a factor eases in the future, such as a slowdown in the upward rate of risk-free interest rates or signs of a high level of inflation, the pressure on US stocks will be reduced in stages. In this section, we try to compare similar periods in history to quantitatively analyze the possible corrections in U.S. stocks.
3.1 Comprehensive analysis of indicators
In this section, we combine the above types of indicators to find historical periods that are more similar to the present. At present, the environment we are in is: 1, the EPS growth rate of the S&P 500 is lower than the growth rate of the previous year (positive or negative, as long as the value is lower than the previous year); 2, the ten-year bond yield rebounded within the year (the US Treasury yield changed positively during the year); 3, the CPI year-on-year growth rate was higher than that of the previous year. There have been five years since 1965 that have been the same as they are now: 1969, 1974, 1977, 1990 and 2005.
Judging from the trend of the S&P 500 index in 5 similar years, except for 2005, the S&P 500 in other years recorded negative annual returns. In 1969, 1977 and 1990, the maximum decline of the S&P 500 index was about 15%, and the maximum decline of the S&P 500 index in 1974 was close to 35%. Since the beginning of 2022, the S&P 500 index has fallen by 12.71% in the year. It can be considered that within the range of influencing factors currently visible, the adjustment range of about 15% in the year has mostly reflected the currently known bearish factors. In the future, the further sharp break of the US stock market will need to be further deleveraged events or recession concerns to promote. On average, the S&P 500 bottomed out around the 190th trading day over five time periods, with an average decline of 11.3% at the end of the year compared to the beginning of the year.
At the same time, these years also have a similarity, except for 2005, which is accompanied by local wars or conflicts, and there is more or less the support of the United States, and the wars in Iraq and Afghanistan in 2005 are actually continuing. When there is obvious downward pressure on the US economy, it is often a common means for the United States to achieve the purpose of returning capital to the United States by instigating local wars in non-US mainland areas, and this time is no exception.
From the current range of the US pee (36.31 S&P 500PE in April 2022), history shows that when the S&P 500 index is in the current PE range since 1900, the maximum average decline in the next 1 year is about 10%, which is comparable to the maximum decline of the S&P 500 index during the year, but there is still room for decline in 5 years. At the same time, the recent divergence between the 10-year US Treasury yield and the trend of selected SPDR funds in the US financial industry also indicates that economic downturn concerns have begun. In this case, the upward trend of us Treasury yields can no longer drive the rise of value stocks, on the contrary, if the upward rate of the 10-year US Treasury yield slows down due to economic downturn concerns, growth stocks will outperform value stocks in stages.
3.2 Impact on A shares
We calculated the correlation matrix between the CSI 300 Growth Stock Index, the CSI 300 Value Stock Index, the CSI 300 Growth Stock/Value Stock Ratio, the ARKK Innovation ETF, the S&P 500 Index, the 10-year China Bond Yield, the 10-year US Treasury Yield, the US-China 10-Year Spread, and the US-China 1-Year Spread. The results show that the negative correlation between the CSI 300 Growth Stock Index and the CSI 300 Growth/Value Ratio and the 10-year US Treasury yield is significantly higher than the negative correlation with the 10-year Medium Bond yield. This shows that at a time when foreign capital participation in the A-share market is getting higher and higher, the trend of A-shares is increasingly affected by the international macro environment. At the same time, it can be found that there is a high degree of synchronization between the CSI 300 growth stock index and the famous Wood Sister ARKK innovative ETF. This suggests that growth stocks will remain under pressure against the backdrop of a rapid rise in overseas interest rates. However, once the upward speed of global risk-free interest rates slows down or overseas inflation shows signs of falling back at a high level, the pressure on A-shares, especially growth stocks, will be reduced, which needs to be closely observed.
At the same time, we found that there is also a high degree of synchronization between the trend of A-shares and the balance sheets of the four major overseas central banks year-on-year, and the synchronization is better than the ten-year US Treasury yield. The balance sheets of the four major overseas central banks fell the fastest year-on-year after the beginning of 2021, and the second-order derivative has slowed down. According to the Calculation that the Federal Reserve will shrink its balance sheet by $95 billion per month from May 2022 until mid-2023, and the Ecbbank will stop expanding its balance sheet after June 2022, the year-on-year growth rate of the balance sheets of the four major central banks will bottom out in the fourth quarter of 2022, which may correspond to the shock downward adjustment that began at the A-share CSI 300 Index level in early 2021.
(Thanks to intern Ma Zhibin for his contribution to this article)
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[1] Greenspan Alan, “Globalization”, 10 Mar 2005, Council on Foreign Relations.