In the long term, shares follow the underlying earnings trend. Many analysts are therefore engaged in predicting this. However, there is no fixed relationship between earnings (growth) and valuation. There are many factors that influence this. The annoying thing in the coming months is that both profits and valuation are likely to come under pressure. Earnings because of the recession orchestrated by the Federal Reserve, valuation because of rising inflation and interest rates.
At present, the stock market is still valued as if inflation were a temporary phenomenon, despite the fact that there are more and more signs that inflation will remain structurally high in the coming years.
This is more true for the United States than for Europe; in Europe, there are other reasons (mainly energy) for an inflationary shock. It causes a recession, but perhaps not a sharp rise in wages.
In both countries, valuations are normalising. The weight of the Technology sector must go down and the weight of the Energy sector must go up. The result is large differences between sectors and companies, a paradise for stock pickers.
Furthermore, shares were much more attractive than bonds for a long time. Today, the difference between the effective yield of corporate bonds and the dividend yield of comparable shares is no longer so great.
In some segments - such as small caps - the risk premium has risen sharply, but small caps are more sensitive to the economic cycle than others.
Lower earnings estimates and falling valuations make it difficult to determine how great the downside risk still is. If inflation becomes more structural, there is still a lot of room for improvement.
Profit margins are still historically high. In the second half of the year, revenue growth will slow down and costs will continue to rise with a certain time lag. This negative shear directly affects the valuation.
US equities are also still highly valued on several other valuation measures. There is a lot of downside risk there as well.
When looking at valuations, one tends to look back a long time. Yet there are also sufficient arguments why we should not go back to the extremely low valuations of, for example, the early 1980s. Thanks to the Internet, transparency on the stock exchange has improved dramatically. Many rules have also been added to ensure that investors are better protected. In an extremely negative scenario, there is always the central bank that can intervene.
The bottom is also determined by sentiment. If everyone is negative, this automatically means that when someone changes their mind, that person has become more positive and therefore prices rise. Moreover, panic is often highly concentrated during corrections, making extremely negative sentiment a much more reliable indicator than extremely positive sentiment.
In addition to valuation, money flows can also play a major role. Option expirations tend to amplify price movements. In this respect, the gigantic expiration in June is not positive.
To determine the risk premium, a comparison is often made with the return on a government bond. It is better to compare with the return on corporate bonds. This can still rise further.
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