There are two silver linings to the current stock slump for bullish investors.
When the stock market drops, investors may feel like the sky is falling. Barring the rather extreme outcome that an economic downturn is about to emerge, however, there are always silver linings to a market pullback.
The S&P 500 is down almost 9% from a record close set in February, and the decline has hit most sectors.
The root causes are President Donald Trump’s 10% tariffs on China and 25% tariffs on Mexico and Canada, collectively on a few hundred billion dollars worth of goods. That’s a low-single-digit percentage of total annual U.S. economic activity, so the additional inflation that results would only put mild strain on consumer spending. The larger question is the extent to which business investment—and hiring—will slow down as a result of the uncertainty. The market is concerned about slowing economic growth.
Combine with that with the fact that the S&P 500 came into the tariff announcements trading highly priced at 22 times aggregate expected earnings for the coming 12 months. That height left plenty of room for the index to drop, and it has. Valuation is now at just over 20 times earnings. The multiple now reflects the risk that this year’s earnings will come in several percent lower than analysts’ current forecasts.
The primary silver lining for bullish investors is that the 10-year Treasury yield has fallen to about 4.2% from a high of almost 4.8% this year. True, lower yields are a result of the fact that economic growth could slow down beyond the immediate term, but it also puts a floor on the market. As long as the economy avoids recession—and the most recent reading of gross-domestic-product growth was still above 2%—corporate earnings will still grow while the safer alternative to equities (bonds) provide lower returns. Lower bond yields alone cause investors to take on risk and seek out better returns in stocks.
In fact, 22V Research’s Dennis DeBusschere writes in a report that the S&P 500 could get a boost from here with “the 10-year yield trending to 4%, in a non-recessionary backdrop (without an earnings-per-share collapse).”
Stocks may soon stabilize as a result. Already, the pace of losses is slowing down, with the S&P 500 down just over 1% Tuesday, then moved into the green in the afternoon, after having dropped almost 3% Monday. This means the ratio of sellers to buyers is becoming slimmer, as more buyers come into the market. It doesn’t mean the slump is over, but it indicates that it’s likely the bulk of it is over.
That’s consistent with the second silver lining, which is that companies may start buying back more of their own shares. Lower stock prices incentivize companies to buy back more stock.
Even if companies’ reap less free cash flow than currently expected, they could boost their buybacks. The portion of aggregate free cash flow that S&P 500 component companies use to repurchase shares has dropped to just over 30% in recent quarters from over 40% in 2021, according to Citi. Big Tech companies have prioritized spending hundreds of billions of dollars on artificial-intelligence capabilities. As these firms move past those large investments, spending increases will slow down, and buybacks should come off the back burner. So even if cash flow disappoints, companies may still have room to increase the amounts of their repurchases, especially if cash flow continues to grow.
“Cash-flow deployment could incrementally shift from capital expenditures to buybacks should further equity-price weakness unfold, writes Citi strategist Scott Chronert.
Increased stock buybacks should bolster stocks. It reduces the number of shares outstanding, which increases earrings per share.
All of the analyses on buybacks and bond yields are just longer ways of explaining that stocks are arguably becoming more attractive.
More buyers are likely to return soon to support the market.