Deflated: falling valuations drag stock prices down to earth

Stock valuations are falling fast, giving investors a potential opportunity to snap up stocks that may have been overvalued just a year ago.

Take industrial bellwether Caterpillar Inc. Last year the Illinois-based heavy machinery manufacturer was trading at 27 times earnings — that is, the price investors paid for one share of Caterpillar was 27 times its earnings per share, a valuation known as price-to-earnings. The overall price-to-earnings ratio for the S&P 500 reached its highest level in at least two decades by early 2021.

Now, with inflation at a 40-year high and the Federal Reserve ratcheting up interest rates at the fastest pace since Pink Floyd’s “The Wall” was in the charts, investors are having second thoughts about how much to pay for stocks.

This week Wall Street was valuing Caterpillar stock at just 17 times earnings, a steep drop also seen by retail giant Target and other shares.

The ratio of stock prices relative to a company’s earnings is now hovering close to a 10-year average for the broader S&P 500 index.

“There’s some reasonable values out there,” said Brad McMillan, chief investment officer for Commonwealth Financial Network. “Investors don’t need to be terrified at this point as long as they realize volatility isn’t going away.”

The drop in valuations has come from two fronts throughout the year. Earnings growth has been steadily shrinking for the entire S&P 500 since the beginning of the year. Company valuations have also been hit hard by the Fed’s aggressive policy to raise interest rates in its effort to slow economic growth and tame inflation. Higher interest rates make stocks generally less attractive, while increasing yields on areas of the market that are traditionally considered less risky, like bonds.

The U.S. economic outlook remains very uncertain amid stubbornly hot inflation squeezing consumers and companies, while the Federal Reserve aggressively raises interest rates. The latter has made borrowing more difficult for both consumers and companies, while raising the possibility that the economy slips into a recession.

Wall Street is still trying to price stocks for a likely downturn in the broader economy and some of the biggest companies in the S&P 500 are still pricey relative to their earnings and the 10-year average. Tesla currently has a price of roughly 40 times its earnings looking forward over the next 12 months. That’s well below the nearly 200 level it hit in late summer, but still far higher than the broader average for the S&P 500.

Analysts have said that valuations have some more room to fall in the months ahead. Stubbornly hot inflation has been slowly squeezing consumer spending and costs for businesses throughout 2022. Companies have seen earnings drop significantly and forecasts for the rest of the year and into 2023 remain subdued.

“We’re seeing a tremendous number of advisers putting money into Treasurys because that can pay to wait,” McMillan said. “That will probably keep equities constrained.”

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