But a new Vanguard analysis finds that reduced expectations for corporate earnings may be priced in to the S&P 500 Index to a greater degree than some observers believe, suggesting a more sanguine outlook.

With interest rates and recession risks rising, we do believe that the outlook skews lower for equities in the medium term. But we caution investors against putting too much faith in short-term consensus earnings estimates and overlooking equities’ long-term earnings power. Our favored tool for equity return projections looks out over 10 years, focusing on long-term earnings growth potential over economic and market cycles.

The 12-month-forward consensus earnings-per-share forecast for the S&P 500 Index has maintained an upward trend this year thanks to consistent demand and stronger corporate pricing power in a rising inflation environment. The disconnect between market and analysts’ views implies that the entire equity market sell-off to date is attributable to valuation contraction. Should analysts revise earnings forecasts lower in anticipation of slowing growth, prices would have to fall further to maintain current valuations.

But equity prices are based on more than just the next 12 months’ earnings, said Ian Kresnak, a Vanguard investment strategist and a member of the Vanguard Capital Markets Model^® (VCMM) research team.

“The market is able to look through fluctuations in the business cycle and focus on long-term growth potential,” Kresnak said. “Valuations—the price investors pay for a dollar of earnings—are explained by the expectation of long-term earnings growth as well as by economic factors such as interest rates and inflation. The market could already be pricing in some downward revision to 12-month-forward earnings. Vanguard recommends that investors instead focus on longer-term earnings estimates when setting return expectations.”

Vanguard’s analysis found that the rise in interest rates and inflation explains some of the S&P 500 Index’s 13.3% decline from the start of the year through July. “Given that the market seems to believe that the Federal Reserve won’t raise interest rates as high as once expected because of falling inflation and rising recession risks, part of the sell-off could be due to the market’s expectation for lower earnings in the case of a recession,” Kresnak said. “In that case, forward earnings would have to fall by more than what is priced in to warrant further sell-off, barring further deterioration of market sentiment.” 

To be sure, short-term market moves are unpredictable, and investors could be pricing in other risks besides just earnings (for example, further geopolitical tensions or a higher discount rate). Our analysis isn’t meant to suggest that equity prices can’t fall farther or that further sell-offs can’t be related to earnings. Rather, it emphasizes our model for long-term investors that considers average 10-year earnings relative to their fair value given economic conditions.

As of the end of July, U.S. equities’ cyclically adjusted price/earnings (CAPE) ratio was 13% above the upper limit of our fair-value estimate, compared with 32% above the upper limit at the end of 2021. By that measure, U.S. equities still appear overvalued, though not to the same degree as at the start of the year.

"It's hard to say when or how CAPE will return to fair value,” Kresnak said, “but this is the main reason our time-varying asset allocation framework is less constructive on U.S. equities relative to global bonds and international equities.”

• For a disciplined investor, allocations that fluctuate (article and video, issued July 13, 2022)
• Global equity and fixed income outlook (article, issued July 13, 2022)
• Is recession inevitable? (video, issued July 13, 2022)