Earnings Are Not Enough: Stocks Need Easy Credit

Credit markets are still relatively supportive of stocks, but at the margins, less so. Russ discusses the implications.

As the recent equity meltdown demonstrated, sometime even stellar earnings are not enough. While U.S. stocks are still having a pretty decent year, it would be an even better one if not for the fact that price-to-earnings (P/E) multiples have contracted (see Chart 1). Whether they rise again (unlikely), stay at current levels or fall will largely be determined by credit markets and broader financial market conditions.

financial market conditionFinal

Last May, I suggested that despite rising rates and a stronger dollar, financial conditions remained easy, or at least enough to support stocks. Since then, the U.S. equity market has advanced, albeit a lot less then week ago. Today the situation looks similar, albeit not as supportive. While financial conditions remain accommodative, they’re becoming less so. Consider the following:

  1. A higher dollar. The Dollar Index (DXY) is 4% above the May low and nearly 9% above the February bottom.
  2. A big backup in yield. Year-to-date, both long-term and short-term rates have risen significantly, with 2 year and 10 year Treasury yields up 100 basis points (bps, or one percentage point) and 85 bps respectively. The recent backup in rates is the largest since the second half of 2016.

A stronger dollar and higher rates are causing a tightening of financial market conditions. One proxy, the Goldman Sachs Financial Conditions Index (GSFC), has tightened by about a quarter point since mid-September and by a full point since late January. Tighter financial conditions help explain the rise in volatility. Historically, a one point change in the GSFC Index has been associated with a 3.5 point rise in the VIX.