It’s easy to be an optimist when sailing is smooth. The real test comes when things get rough.

That’s where true-believer bulls find themselves as momentum reverses in equity markets, with pro-stock arguments based on everything from valuations to financial conditions suddenly in question as Federal Reserve hawkishness revives. Early returns aren’t great. The S&P 500 is down 5 per cent in three days.

Worried investors are wondering the same thing: Is this the start of the real crash, or will the things that put a floor under the last one keep the new selloff from snowballing? Charts and valuation tables are being dusted off for guidance on whether the levels of mid-June in equities can hold as the low point of the 2022 market.

“It really stems on what you thought the driver was of the rally. So if your belief that the rally was 100 per cent predicated on a Fed pivot, then of course you think you’ll have to change gears and the market’s heading to new lows,” Art Hogan, chief market strategist at B. Riley, said in a phone call. “And if I believed the catalysts had nothing to do with the narrative around a pivot, then I feel convinced that we’ve seen the lows for the year.”

Valuation has been a central plank in arguments that the worst has passed for bulls in 2022. The S&P 500 is trading around 16.4 times next year’s earnings estimates, around the level where it bottomed versus 2022 forecasts 13 weeks ago. The problem with the model is its reliance on analyst predictions. Nobody is quite sure where earnings will land in 2023, and any evidence they’re crumbling would be unwelcome in this nervous market.

“Forward earnings are an enigma at the moment,” said Mike Bailey, director of research at FBB Capital Partners. “Most of the macro trends would suggest some earnings pain next year and we could be at the tip of the iceberg with 2023 earnings down only 3 per cent from peak.”

Earnings in the S&P 500 are forecast to rise 6.4 per cent to US$240.50 a share in 2023, according to analyst estimates compiled by Bloomberg Intelligence. A measure of US profit margins just hit the widest since 1950, suggesting that the prices charged by businesses are outpacing their increased costs for production and labor, government data showed this week.

Stocks dropped for the third straight day on Tuesday as traders recalibrated expectations in response to the Fed indicating it will keep raising interest rates to damp inflation. The S&P 500 fell more than 1 per cent and the rate on 10-year Treasuries hovered around 3.10 per cent. 

The stock market suffered a shock due to the hawkishness of Chair Jerome Powell’s tone, said a Morgan Stanley team led by Mike Wilson. The second half of the year will be determined by earnings expectations for 2023, in their view, and equity investors should be laser-focused on this risk.

“The equity market became a victim of its own momentum over the past few months as CTAs and other price insensitive buyers drove valuations to unrealistic levels,” they wrote in a note. “While P/Es have come back down, they remain well above fair value based on our equity risk premium framework.”

At the same time, second-quarter earnings held up much better than expected, adding credence to the argument that the current selloff might not mean a full retracement of gains, said Victoria Greene, founding partner and chief investment officer at G Squared Private Wealth. 

“Fundamentals for companies are actually pretty solid still, and a lot of companies aren’t stretched, and maybe a lot of the supply chain, inflationary, strong dollar might be easing up a little bit,” she said in an interview. “The dollar shot up in Q2 and if it stays a little bit lower or doesn’t continue on its rise, that’s less pressure in the second half than some people were thinking might happen.”

At the start of July, severe damage to stocks had pushed a Bloomberg financial conditions measure to the tightest since 2020. Falling stocks were a key contributor to the tightening, arguably leading Federal Reserve officials to leaven the harsh tone of their inflation-fighting talk over the summer. Could the same thing happen again if selling picks up in the S&P 500? Yes, but at a potentially high cost, says Greene. 

“If things get bad enough as the Fed slows down, that’s not good for earnings,” she said. “You’ve got to find that balance of we need the world to get bad enough that the Fed slow down, but we need the world to stay good enough that everybody still is profitable. And that’s the whole threading of the needle and avoiding the hard landing.”

A few analysts have argued that the huge sums parked in buy-and-hold investment products are cushioning equities from a bigger rout. Such accounts total US$6.7 trillion, more than one-sixth of the US market, with their share among all domestic-focused equity funds rising 4 percentage points since the end of 2020, data from Bloomberg Intelligence show. 

But there are just as many arguments saying index money increases volatility by letting people sell large swaths of equities with a single click.

“With the rise of passive investing, I think it allows investors to sell their portfolios quicker in relation to new data,” Jeff Schulze, investment strategist at ClearBridge Investments, said in an interview at Bloomberg’s New York office. “It creates an environment where selloffs have been much quicker and the rebound has been much faster than what we’ve seen in previous economic expansions.”