Decelerating Economic Growth Will Sink Stock Market Valuations

Economic data continue to show that the US economy is slowing down, and perhaps we may even have seen the peak growth rate. Although some people choose to ignore economic trends, these trends are highly correlated with the changes of earnings, price-earnings ratio and stock market valuation over time. They are very important and should be the concern of all investors, no matter what kind of investors they think they are. Although many tracked trends may take time to develop, it is better to look ahead to what may happen in the next 6 to 9 months.

The current trend strengthens the core belief that with the slowdown of economic recovery and the sharp decline of profit growth rate, the stock market will experience a period of rapid multiple compression.

ISM manufacturing data was lower than expected this week. However, more importantly, it is down from last month to 60.6, which is the lowest reading since January. This is important because the second quarter of 2021 is expected to be the peak of GDP growth. The slowdown in ISM investigation seems to indicate that this may be the case.

Again, this is important, because if GDP growth peaks, the earnings growth rate of the Standard & Poor's 500 Index seems likely to peak and may slow down in the next few months.

We also know that in the past 15 years, the price-earnings ratio often leads the growth rate of earnings per share by about 3 months. This means that the stock market expects the profit growth rate to accelerate or slow down.

Therefore, if the economic cycle has peaked and the growth rate may slow down, it seems reasonable to assume that the P/E ratio will fall before the growth slows down. This means that the current 12-month forward P/E ratio of 21.3 cannot be maintained. If it can be maintained, the stock market will probably need to be adjusted back or sideways for a long time.

The 18-month long-term forecast has told us that the profit growth rate in 2022 is expected to drop from the current 21.3% to about 11.6%.