Raising S&P Earnings Estimates
In our opinion, the crux of the 2021 stock market can be defined by two components: 1.) a strong earnings rebound and 2.) historically easy monetary policy.
Securities markets are always complex and cannot really be explained by two simple factors. Clearly there have been other influences this year such as the positive support from fiscal stimulus and promises of more stimulus ahead or the negative drag from the spread of the Delta virus variant, China’s crackdown on technology companies and the threat of rising corporate and individual taxes and fees. But perhaps the most unique and interesting development of 2021 is the appearance of a new generation of investors and the growing influence of social media on stock market activity. As a result, market volatility has increased driven predominantly by enthusiastic day traders monitoring message boards such as WallStreetBets on Reddit. Plus, there are a slew of geopolitical issues this year such as the slowing of the Chinese economy, China’s tightening grip on Hong Kong and Taiwan, the geopolitics of climate change, reversals in US energy policies and rising prices of oil, disputes between Poland, Hungary and EU institutions, Japan’s struggle with the Delta variant, and more recently the unfortunate global threat that the US pullout from Afghanistan, the fall of Kabul and the rise of the Taliban poses for the world.
Still, despite all these factors, investors can and will absorb a lot of bad news if earnings growth is strong – and to date, growth has definitely been strong. According to IBES Refinitiv’s report “This Week in Earnings”, with 476 of the 500 S&P companies reporting second quarter earnings, growth is expected to be nearly 95% YOY. Companies have been reporting quarterly earnings that are nearly 16% above estimates which compares to the long-term average surprise factor of 3.9%. This follows on the heels of IBES Refinitiv’s earnings growth estimate for the first quarter of 53% YOY. So as the second quarter earnings season ends, we are raising our 2021 SP 500 earnings estimates from $190 to $200, a 5% increase. However, this is a 19% increase from our December 2020 estimate of $168.60. We are also raising our 2022 estimate from $211 to $220, a 4% increase. In both cases we believe these estimates could prove to be conservative. See page 15.
This is good news for investors and this surge in earnings growth certainly supports equities. However, the easy comparisons from the pandemic-wreaked earnings quarters in the first half of 2020 are mostly behind us, and earnings growth is expected to slow to more typical levels of 30% in the third quarter and 21.6% in the fourth quarter. Despite the fact that strong gains in earnings have supported gains in the SPX, as seen in the charts on page 3, the run-up in the SPX relative to the gains seen in earnings has produced a significant valuation gap in both trailing and 12-month forward operating earnings. This valuation gap is similar to the one seen prior to the 2000 top. Another similarity between the 1997-2000 bull market and the current advance is the participation of a new generation of investors. A new generation of investors and a valuation disparity often go hand in hand and this characteristic of today’s market concerns us.
Inflation is a tax on consumers and investors
While earnings have been strong in 2021, valuations still remain unusually high, and this is particularly true when inflation is taken into consideration. We often use the sum of inflation and the trailing PE as a benchmark to indicate when PE multiples are appropriate for the current level of inflation or as a warning when multiples get too high. In July with the CPI rising 5.4% YOY and the trailing PE at 24.5, the sum becomes 29.9, well above the standard deviation range. Since the top of the standard deviation range is 23.8, we call this The Rule of 23. See page 4. Note that the unusually high and sustained readings seen in this indicator recently are similar to those seen in 1999-2000 prior to the second worst bear market in history. Again, similarities to the 2000 market continue to grow.
Inflation will impact all investments. With 3-month and 10-year Treasury rates at 0.05% and 1.29%, respectively, equities remain competitive investments to fixed income. However, the chart on page 5 compares the history of interest rates and inflation and this chart suggests that unless inflation quickly drops below 1% YOY, interest rates on both the short and long end, are much too low and are likely to move higher. More ominously, a close inspection of the chart on page 5 also shows that a sharp rise in inflation, like that seen in 2021, has triggered eight of the eleven recessions seen over the last 75 years. This helps to explain the predicament the Federal Reserve faces this week as it meets in Jackson Hole WY. Interest rates are too low and accommodating given the level of inflation and the strength of the US economy. However, the pandemic-stricken economies of Europe and parts of Asia imply global growth may not be strong enough to withstand a change in Fed policy. Yet if the Fed allows inflation to continue to rise, it will inevitably end with even tighter and hawkish monetary policy in the years ahead which will almost guarantee an economic recession. It is not a simple problem. But it has been our view that the Fed needs to, and should have already, moved to neutralize its easy monetary policy in order to stifle inflation before it becomes ingrained in the system. This week we expect the Fed to steadily move the consensus view toward a reduction and possible elimination of quantitative easing. This is a necessary step to ensure the Fed is not stoking the flames of inflation. However, it will eliminate one of the two components that has underpinned the stock market’s advance.
Inflation is also having a negative impact on businesses. The NFIB Optimism Index decreased 2.8 points in July to 99.7, nearly reversing the 2.9-point gain in June’s report. Six of the 10 Index components declined, three improved, and one was unchanged. The NFIB Uncertainty Index decreased 7 points to 76, sales expectations decreased 11 points to a net negative 4 percent, owners expecting better business conditions over the next six months fell 8 points to a net negative 20, and earnings trends over the past three months declined 8 points to a net negative 13 percent. In sum, small businesses are becoming more concerned about their future given the current inflation and political environment. See page 6.
We are still focused on the Russell 2000 index (RUT – 2230.91) which has been trading in a sideways range for all of 2021. We believe it may give us clues about the stock market’s intermediate term direction. At present, the 200-day moving average (2160.82) is acting as support and the converging 50-day (2241.27) and 100-day (2247.88) moving averages — which are now decelerating — are acting as resistance. A breakout in the RUT from this narrowing range may define the broader market’s intermediate-term trend. There have been similar patterns in the RUT (trading between a rising 200-day moving average and decelerating 50- and 100-day moving averages) in the first half of 2011 and the second and third quarters of 2015. In both of these previous cases, the RUT broke below the 200-day moving average and this was the trigger for relatively sharp and fast corrections totaling 19.4% and 14%, respectively, in the SPX. Also worthy of note is the continued weakness in the 25-day up/down volume oscillator, which at 0.64 this week, is minimally above the lower half of neutral. This low reading implies that since early July volume has been as strong or stronger in declining issues as the volume seen in advancing stocks, i.e., investors have been selling into strength. And this week the 10-day average of new lows hit 101, before dipping to 99 on Tuesday. Nevertheless, this is close to the 100 new lows per day that defines a bear market. Daily new highs are still averaging 194, but the rise in daily new lows has shifted this indicator from positive to neutral. In short, we remain cautious and would focus on stocks with good value.
PLEASE NOTE: Unless otherwise stated, the firm and any affiliated person or entity 1) either does not own any, or owns less than 1%, of the outstanding shares of any public company mentioned, 2) does not receive, and has not within the past 12 months received, investment banking compensation or other compensation from any public company mentioned, and 3) does not expect within the next three months to receive investment banking compensation or other compensation from any public company mentioned. The firm does not currently make markets in any public securities.