Earnings headwinds and a compressed P/E ratio pose challenges for stocks.

The direction of stock prices is influenced by two factors: investors' expectations of earnings growth and the market multiple, which reflects the price-to-earnings ratio.

Both are under pressure.

Multiple compression

According to Matt Maley from Miller Tabak, as long-term interest rates increase, it will lead to a decrease in the acceptable P/E ratio, resulting in 'multiple contraction'.

After a 12-year period of expansion, these multiples have started to shrink.

During economic expansions, multiples (P/E ratios) typically increase as investors anticipate higher future earnings and drive up stock prices.

During times of economic prosperity, when investors have access to inexpensive funds and are willing to take on debt, they may expand their investments.

Since the Great Financial Crisis, the Fed's balance sheet has experienced a significant increase, reaching nearly $9 trillion.

It is reasonable to believe that a significant portion of that money has been invested in the stock market.

The S&P 500 is currently trading at 19.6 times 2022 estimates, which is higher than its historical range of 15 to 17. This expansion occurred after the Fed injected large amounts of money into the economy in 2009 and 2020, causing the multiple to reach almost 22 in early 2018 and then expand further following the Covid pandemic. However, the multiple has been decreasing since its peak.

You can also look at the abnormal market returns.

The S&P 500 has experienced an unprecedented growth of approximately 15% annually since 2009, surpassing the historical average of around 10% returns.

The Fed is partly responsible for the 5 percentage point yearly outperformance of many traders.

If the Fed is responsible for the excess gain, it is reasonable to assume that withdrawing liquidity and raising rates may lead to sub-normal (below 10%) returns in the future.

Netflix: Extreme multiple compression

A lower multiple due to higher rates and a less rosy business outlook can result in dramatic consequences.

Netflix's multiple has decreased significantly over the past two years, despite its stock price remaining the same. In 2020, the company was trading at 88 times 2020 earnings, but now it is trading at only 34 times 2022 estimates. This represents a significant decrease in investor confidence in the company's future earnings potential.

What caused the sudden drop in the multiple? Investors are no longer willing to pay as much for the future stream of earnings as they did two years ago.

While Netflix faces a challenging business environment, other companies may still have good business climates, but their multiples have been cut.

Earnings: Time to slow down?

Despite a slight contraction of the multiple on the S&P 500 by the end of 2021, the earnings rebounded by 47% for the full year, propelling the S&P's 27% gain last year.

Expectations for 2022 are lower than anticipated, with a predicted increase of approximately 8%.

The company's earnings growth rate is closer to the historic range of approximately 6%.

Strategists are concerned that the market is vulnerable due to multiples contracting and modest earnings growth.

Bank of America's Savita Subramanian stated in a recent client note that the earnings momentum has slowed and there are risks to 2022 EPS due to continued inflationary pressure.

She stated that the P/E ratio contraction is expected to outweigh the EPS growth this year.

Earnings estimates are not rising

If you anticipate that the S&P will experience a significant earnings increase in 2022, as it did in 2021, you may be disappointed.

In 2021, it was common for companies to report earnings that exceeded analysts' expectations by 20%.

That is not happening anymore.

According to The Earnings Scout, 76% of the 60 companies that have reported so far are beating estimates, which is high but below the 88% beat rates from the previous quarter. Additionally, these companies are beating by only 7.4%, which is significantly lower than the 15% beat rates they reported last quarter.

The S&P 500 typically outperforms by 4%-6% within the historic range.

Another factor driving market growth last year was the consistent and persistent upward revisions to future earnings projections.

That, too, has slowed dramatically.

The S&P 500's first quarter earnings growth estimates have decreased from 7.5% to 7.0% since January 1. Despite this slight decline, earnings estimates had been increasing throughout 2021.

Nick Raich from The Earnings Scout stated in a note to clients last week that actual earnings growth is slowing down and will persist for at least two additional quarters. Additionally, his research shows that the Fed's interest rate hikes have not yet been factored into the 2H of 2022 EPS estimates.

Higher costs and margin erosion

The pressure on market multiples and earnings is likely to continue.

The profit margin, which is the amount of profit corporations retain after paying expenses, is a significant pressure point for earnings. It is likely that rising labor and raw material costs will persist until the second half of the year.

The four companies, namely CSX, Sherwin-Williams, PPG, and Ecolab, reported a substantial increase in their costs in their earnings reports. While some, such as CSX, were able to offset these costs with price increases due to higher fuel and labor expenses, others have struggled to do so.

How far could the S&P 500 drop?

What is the potential drop of the S&P index based on your perspective on the economy, the strength of corporate America to maintain price increases amid rising costs, and the impact of interest rates?

While the 10yr note yield was below 1.5% in both 2012 and 2016, the S&P was trading at 13x earnings in 2012 and just above 17x in 2016, despite the low rates being on an historic basis.

If the S&P were to fall below 3,500, it would mean that the stock market has fallen into the middle of the range, assuming the earnings estimates don't fall as they typically do, according to Maley.