From time to time in these Market Commentaries we’ve discussed the fact that earnings estimates for the S&P 500 were on a consistent downtrend well before COVID-19 appeared. In fact, analysts had been reducing their estimates every month for nearly a year and a half starting in September, 2018. Among the factors weighing on earnings growth were the fading effects of fiscal stimulus (tax cuts and government spending increases); the lagged effect of Fed interest-rate hikes; the economic deceleration outside the US; a sharp reduction in business investment driven by policy uncertainty; growth-restraining levels of debt; economic inequality and the negative effects of the trade wars. The negative impact of those factors was then exacerbated by the effects of COVID-19 and the associated shutdowns. So following many months of negative earnings revisions through February, 2020, the consensus estimates fell much more in the months of March, April and May. The cumulative decreases in consensus estimates for 2020 and 2021 were 35% and 22%, respectively, from peak to trough in May.
For the past couple of months, though, earnings estimates appear to have finally turned a corner. The consensus estimate for 2020 currently stands at $128.05, which is a couple percent above the trough of $125.42 in May. The current consensus estimate for 2021, at $162.10, is about 26% higher than the current estimate for 2020. That’s the good news. The bad news is that despite a meaningful sell-off over the past several days, the current price-to-earnings multiples on the 2020 and 2021 consensus estimates are still at very high levels of 26.0x and 20.6x. At those valuation levels, it’s not hard to see how investors got a little nervous over the past few days. The Nasdaq has suffered a 10% correction while the S&P 500 is down about 7% from its high. Will investors step in to “buy the dip” again this time? If so, where is the confidence coming from?
The most popular and credible argument for the market’s continued resilience is the interest-rate argument. The simple fact is that both the S&P 500 earnings yield (earnings dividend by stock price) and the S&P 500 dividend yield (dividend divided by stock price), at 4.8% and 1.8%, respectively, are well above the returns you can get elsewhere without assuming significant risk. The 10-year Treasury bond, for example, is currently yielding just 0.7%. If you prefer to avoid maturities that far out in the future you’ll end up getting a yield significantly lower than that. But perhaps more importantly, the returns available on high-quality stocks may be less risky, in some cases, than buying a 10-year Treasury bond. That is because the value of longer duration Treasury bonds can decrease significantly in the event of a sizeable increase in interest rates. The price for a 10-year Treasury bond bought at a 0.7% yield today would lose about 18% of its value if rates were to rise by two percentage points to 2.7%. And 2.7% is still an historically low yield for the 10-year Treasury bond. Given the Fed’s recent posture change and its desperation to generate inflation, we don’t think that type of scenario can be ruled out.
As is the case with stocks, investors must evaluate potential bond investments through a prism of risk versus reward. What is your upside potential in owning a 10-year Treasury bond at a yield of 0.7%? Sure, interest rates could go negative, as they did in Europe, resulting in the potential for some capital appreciation. But by and large, the easy money has been made in the fixed-income world over the course of a 40-year bull market. Stocks certainly have significant downside risk as well, and that may be especially true for some of the recent market darlings that have run up exponentially in price without much fundamental support. But at least with stocks you don’t have an omnipotent central bank working aggressively and directly against your interests.
(As an aside, I should note that Farr, Miller & Washington is finding value in high-quality municipal bonds with relatively short duration, in many cases due to call provisions. This allows us to improve yields while also limiting interest-rate risk.)
My point? The recent pullback in stocks combined with continued low interest rates has begun to change the calculus a bit. Sure, I’d like to see a bigger correction in stocks before I get more bullish. I would also like to see a more convincing rotation from the mega-caps to the more sensibly valued cyclical sectors. But locking in an annual return of 0.7% for 10 years at a time when the Fed is saying it wants to generate inflation above (perhaps significantly above) its previous 2% target may at some point lose its appeal relative to the risk/reward profile of equities. This is especially true if the recent trend of upward earnings revisions continues.