For Markets, the January Selloff Marks the End of the Pandemic

To look at stock valuations, the pandemic might never have happened.

On Monday, the U.S. market closed its worst month since March 2020, with the S&P 500 falling 5.3%. The index has now lost all of its price gains since mid-October. The technology-heavy Nasdaq has retreated further, because the sectors that have performed worse are those more affected by higher interest rates, which the Federal Reserve has said will be a reality this year.

Here is the good news: Relative to the earnings that listed companies are expected to make over the next 12 months, equities have cheapened to roughly where they were in February 2020.

Even before the January selloff, valuations had been falling since May. The S&P 500, the Euro Stoxx 50 and the FTSE 100 are trading at price-to-earnings ratios of 20, 14 and 12, respectively. And such calculations include the tech companies that have arguably notched permanent gains from a more digitized world. Small-capitalization firms are at their cheapest in two decades.

Some in Wall Street have been worried about the possibility of a bubble, as evidenced by the manias surrounding “meme stocks,” blank-check investment vehicles and cryptocurrencies. Most analysts, however, argued that the bull market was a rational response to the fast rebound in economic activity and the Fed taking rates lower to stimulate the economy. When rates are lower, the same stream of cash is more attractive, which justifies higher equity valuations.

Now, 10-year Treasury yields have risen back to pre-Covid-19 levels and stock valuations have followed. During the pandemic, stocks have still delivered total returns of 38%, 14% and 7% in the U.S., the eurozone and the U.K., respectively. This shows that the true force behind the rally has been corporate profits.

The fuel isn’t running out: Half of S&P 500 companies have already reported fourth-quarter results and are beating earnings and sales estimates at a better-than-normal rate. Yet companies aren’t getting credit, with the average stock falling 1.2% on its earnings reaction day, according to data by Bespoke Investment Group.

Other indicators also suggest stocks are oversold. Volatility is elevated and individual investor sentiment is gloomy. Meanwhile, high-yield bonds remain well behaved, suggesting traders don’t really see the economy heading over a cliff. And even if rates rise, the market is rightly skeptical that the Fed will take them above 2%.

There are reasons not to expect spectacular returns from here either. Earnings forecasts for 2022, while very good, are being upgraded less than usual due to the uncertain impact of coronavirus variants. Supply-chain problems persist and fiscal stimulus is ebbing. Valuations are still high by historical standards.

As things stand, though, the bumpy start to 2022 looks more like stocks losing their pandemic premium than an omen of a potential bear market.