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What earnings estimates miss about the equity market


Equity market analysts’ estimates and equity markets themselves can reflect divergent views on the future of corporate earnings. The increasing gap between these views for the Standard & Poor’s 500 Index over the first seven months of 2022 has led some market observers to say the U.S. equity market sell-off is far from over, despite a July rebound.

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.

A disconnect grows between market and analysts’ views 

Notes: Consensus earnings per share reflect Bloomberg earnings estimates of 1,100 contributors in real time.

Sources: Vanguard calculations, using monthly data from Bloomberg from January 1995 through July 2022; accessed August 5, 2022.

Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.

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.”

U.S. equities still appear overvalued, but less so than at the start of 2022

Notes: Our U.S. fair-value cyclically adjusted price/earnings (CAPE) ratio for the S&P 500 Index (from 1957 through July 31, 2022; S&P Composite Index from 1938 to 1957) is based on a statistical model that corrects CAPE measures for the level of inflation expectations and for lower interest rates. The statistical model specification is a three-variable vector error correction, including equity-earnings yields, 10-year trailing inflation, and 10-year U.S. Treasury yields estimated from January 1940 to July 31, 2022. Details were published in the 2017 Vanguard research paper Global Macro Matters: As U.S. Stock Prices Rise, the Risk-Return Trade-Off Gets Tricky.

Sources: Vanguard calculations, based on data from Robert Shiller’s website at, the U.S. Bureau of Labor Statistics, the U.S. Federal Reserve, Refinitiv, and Global Financial Data.

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.




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