The stock market has blasted into record territory following encouraging news about COVID-19 vaccine candidates. At its current level of 3,613, the S&P 500 is now trading at about 21.7x the consensus earnings estimate for 2021. As you can see from the chart below, this is a high multiple relative to the average of about 15.6x forward earnings over the past 20 years. In fact, the current multiple is more than two standard deviations above the long-term average, which means that the S&P 500 P/E ratio has only been this high less than 5% of the time over the past 20 years. Of course, we have to account for the fact that earnings growth is expected to be very strong over the next couple of years following an expected drop of about 15% in 2020. So in today’s Market Commentary, we thought we’d run a sensitivity analysis around the possible paths for this bellwether index over the next year.
According to FactSet, the current consensus estimates for S&P 500 earnings are $166.79 for 2021 and $191.21 for 2022. If we compare the 2021 estimate of roughly $167 to the reported $161 in earnings for 2019, it tells us that almost two years of earnings growth was been wiped out due to COVID-19. The big question is will that growth recuperate in relatively short order as a vaccine becomes widely available and the economy rebounds? Judging by the consensus estimate of about $194 for 2022, it seems like analysts are expecting the lost earnings to be recovered very quickly. If we assume the estimate of $194 for 2022 comes to fruition, the 3-year compound annual growth rate in earnings from 2019 to 2022 comes to about 6.4% – not much different from long-term averages. In other words, the pros are telling us there will be effectively zero longer-term damage resulting from COVID-19!
In the table below, we run a sensitivity analysis using two different variables to determine what total rate of return (including dividends) investors in the S&P 500 can expect over the next year. The first variable (horizontal axis) is the two-year annual growth rate in earnings from 2020 to 2022. Based on the consensus estimates, S&P 500 earnings are currently expected to grow a little over 19% annually for the next two years. As noted above, this outsized growth reflects a snapback from depressed 2020 earnings related to COVID-19. The second variable (vertical axis) is the price-to-earnings (P/E) ratio on forward earnings. At its current level of 3,613, the S&P 500 is trading at about 21.7x the consensus estimate for 2021 earnings of $166.79. We already know from the chart above that this is an historically high level.
The intersection of the gray shaded areas in the table shows base-case assumptions. The figure of 18% is the total return that investors would earn over the next year IF the consensus estimate of 19% annual earnings growth remains unchanged AND the P/E multiple stays constant over the next year at 21.7x forward earnings. Are these assumptions realistic?
Let’s be a little more conservative and assume that the forward P/E multiple reverts back closer to the long-term average of about 16x over the next year. Let’s also assume that analysts are overestimating S&P 500 earnings growth over the next two years and the actual figure is closer to 16% rather than 19%. Under that scenario, the total return of investing in the S&P 500 would be -16% over the next year. That’s quite a difference from the +18% under base case assumptions.
Our point is that the expectations built into current stock prices are fairly lofty. Yes, we should have a period of outsized earnings growth following two years of weakness. Is 19% annual growth over the next two years the right figure? It’s definitely not out of the realm of possibility, especially under the right conditions (no inflation, Fed keeps interest rates low, further fiscal stimulus, pent up consumer demand once pandemic ends). However, the expectation that the market will maintain its lofty valuation of 21.7x forward earnings over the next year is likely a bridge too far, especially if economic growth disappoints. Does that mean that investors should be selling everything they own? Of course not. In the year ahead, stock selection will be extremely important. Farr Miller favors a diversified, balanced approach that includes: reasonably priced companies that have benefited from stay-at-home economy, defensive stocks that typically hold up well through good and bad markets, and blue chip companies with significant recovery potential once the pandemic is in the rear-view mirror. The stock market gains have broadened out in the past few months to include reasonably priced blue chip companies with good balance sheets that trade at reasonable valuations. This trend appears likely to continue as investors look past a long, hard winter to a day when this pandemic is largely a topic for history texts.