Equity Outlook: The Great Normalization

The Great Normalization

The S&P 500 struggled again in the second quarter, falling by more than 16% and leaving the index down nearly 20% for the year – its worst first half since 1962. While there are several reasons for the market’s poor performance, including rising inflation, Fed tightening, and fears of a recession, we think the overarching explanation is the unwinding of the Covid economy, a process that we call “The Great Normalization.” The pandemic created several distinct but related economic distortions, including excess liquidity, abnormally strong demand, and unusually low interest rates, and each one is in the process of finding a new equilibrium in real time.

For equities, the Great Normalization has triggered a sea-change in market valuations. Specifically, multiples for the S&P 500 have compressed from about 22x earnings at the beginning of the year to about 16x at the time of this writing. The most common reason offered for the unwillingness to pay a higher multiple on earnings is the rise of inflation and interest rates. On this point we agree. The laws of finance dictate that higher discount rates result in lower valuation multiples. While we do not see an end to the tightening cycle this year, with the market trading in-line with its 30-year average P/E, we suspect most of the damage from multiple compression has been done.