Lavish monetary stimulus has pushed up US stocks since the pandemic hit. Few would argue against that. So what happened when the Federal Reserve said this week it would start pulling back? The stock market jumped of course.
In a news cycle dominated by surging meme stocks and unproven companies with valuations in the billions of dollars, the seemingly unstoppable march of the S&P 500 could look like another example of irrational exuberance in markets.
The benchmark US stocks index has closed at a record high more than 60 times this year, the second-highest number ever, and it still has time for a few more before the end of the month. Despite brief bursts of turbulence — as after the discovery of the Omicron coronavirus variant last month — each has been followed by sharp rebounds and further records.
Those who believe what goes up must come down are getting twitchy. But by some measures, the S&P is looking like a more sensible bet than it was at the start of the year.
“There’s a natural tendency to say, ‘the market is expensive, look how much it’s up’, but that’s kind of a naive way of looking at things,” according to Jonathan Golub, chief US equities strategist at Credit Suisse. “Profits over the past 16 months have been running so much stronger than the price movement of the S&P that multiples have actually come down.”
On a trailing price to earnings basis, the valuation of the index has tumbled from a peak of more than 30 times earnings at the end of 2020 to 23.9 at the end of the third quarter this year, according to Bloomberg data.
That pattern is a big reason why many investors are still feeling pretty optimistic about the outlook for 2022, even as growth rates inevitably slow.
Earnings across the S&P 500 are forecast to increase 45.2 per cent over 2021, according to FactSet, powered by strong revenue growth of 15.8 per cent and a record-high net profit margin of 12.6 per cent.
The figures have been helped by some easy comparisons, given the terrible results reported in the first half of 2020 in particular. But while companies will face much harder comparisons heading into next year, consensus forecasts are still higher than normal: analysts are expecting earnings growth of 9 per cent — compared with a 10-year average of 5 per cent — and revenue growth more than double the 10-year average at 7.3 per cent.
The gains should also be broad-based, with all but one sector expected to experience earnings growth. The only exception is financials, where comparisons will be skewed because this year’s profits were boosted by the reversal of billions of dollars of emergency default provisions that had been taken in the depths of the pandemic’s first wave.
Investors are therefore confident that profit forecasts should translate into decent stock market returns without valuation multiples soaring to more eye-watering levels.
“Earnings growth, strong profit margins, robust revenues and a lot of share buybacks — it all makes a potent cocktail for stock prices,” said Jurrien Timmer, head of macro strategy at Fidelity Investments.
An annual increase in the high single digits, as forecast by Fidelity and other major asset managers such as Northern Trust, may sound a little tame to the rookie traders who were drawn into investing at the height of the pandemic, but would be solid by historic levels.
Even the optimists acknowledge risks to this rosy outlook. Chris Shipley, Northern Trust Asset Management’s head of fundamental equities, is bullish on the outlook for profit margins and profitability, but admits that “the subject everyone is talking about is inflation”.
US producer prices rose at the fastest pace on record last month. So far, companies have managed to offset the pressure by charging more to consumers who are still flush with savings built up during lockdown, but a further sustained increase could eat into profit margins.
In this context, the reaction to Wednesday’s Fed announcements make a little more sense. Chair Jay Powell’s hawkish tone provided some reassurance to investors that the central bank will not let inflation get out of hand, without drastically shifting its long-term policy. Rates are starting from such a low base that, even after completing its projected cycle of rises, they will still be at low levels by pre-financial crisis standards.
The heights of this year’s earnings bonanza are unlikely to be repeated for a while. In Timmer’s words, if the economic cycle is like the seasons, then “we are in early autumn”, with growth on a potentially long downslope. But if the Federal Reserve can maintain its balancing act, he thinks there could still be some time before winter arrives.
“Earnings growth peaked in 2010 after cratering; it slowed from there but still stayed positive for many years . . . depending on monetary policy and financial conditions, that positive but slowing earnings trajectory can continue for a number of years.”