With over 98% of the S&P 500 now having reported first-quarter results, it seems like a good time to take stock. Data obtained from Bloomberg show that S&P 500 earnings grew 50% year-over-year compared to the COVID-impaired results for the first quarter of 2000. The upside relative to expectations was also unusually high at 23%. S&P 500 sales were up 11% YOY in aggregate, which was 4% above expectations. We show the results by sector in the table below along with the sector performance for the year through yesterday. Results varied widely, but each and every sector posted a positive earnings surprise and all sectors but Health Care posted a positive sales surprise. If only all earnings seasons could be like this one!
Unsurprisingly, investors have cheered the outsized growth in earnings and sales. The S&P 500 is up 12%, excluding dividends, so far this year following strong performance last year. Importantly, though, the gains in the S&P 500 over the past year have not translated into higher price-to-earnings multiples. The chart below shows that despite continued increases in the index this year, the price-to-earnings (P/E) multiple on forward earnings (next twelve months) has been flat to down for the past year. This means that earnings growth, rather than P/E multiple expansion, has been driving the gains in the index.
This seems like a good formula for continued investor success. As long as we can maintain the current market P/E multiple, investors should be able to see returns equal to earnings growth plus the dividend yield, which is currently about 1.4% for the S&P 500. But what is already baked in? Well, the current consensus estimate is calling for S&P 500 earnings of $187.59 in 2021, which translates to growth of 36%. That growth is already incorporated into the current P/E multiple using the 2021 estimate, which is 22.4x. Analysts are also currently expecting another 12% earning growth next year for the S&P 500, putting 2022 earnings at $209.71. If those estimates prove realistic and the P/E multiple stays constant, the S&P 500 might be in for more gains ahead. However, we must stress the point that the S&P 500’s current P/E multiple is still nearly two standard deviations above its long-term average of about 16x. Is it realistic to believe that the P/E multiple can stay this high over an extended period?
The single best justification for high P/E multiples has been low interest rates. Low interest rates lead to higher stock valuations because cash flows expected to be received in the future are discounted at a lower rate. Furthermore, low interest rates reduce the attractiveness of bonds and other fixed-income investments relative to stocks. Obviously, stock valuations have benefited from low interest rates since 2008, when the Fed slashed the Fed Funds rate to zero in response to the Global Financial Crisis. The Fed has been willing to maintain both short- and long-term interest rates at very low levels because there has been little sign of inflation. Now, however, the combination of unprecedented fiscal stimulus and continued interest-rate suppression by the Fed is leading many economists to predict sustained high rates of inflation in the years to come. If that indeed comes to pass, stock P/E multiples or earnings growth (or both) could be negatively impacted. This is why every market strategist is watching inflation indicators like a hawk. The long-term tailwind of low inflation and low interest rates could potentially be drawing to a close, putting stock prices at risk.
The chart below is an attempt to quantify returns over the next year based on: 1) the S&P 500 P/E multiple one year from now; and 2) S&P 500 earnings growth in 2022. You will notice that if 2022 earnings growth indeed hits the 12% consensus estimate, the total return (including the 1.4% dividend yield) for an investment in the S&P 500 could be as low as -19% if the P/E multiple were to contract to 16x. On the other hand, the total return could be as high as +14% if the P/E multiple stays roughly flat at about 22.4x. Of course, there is always the possibility that earnings growth comes up lower or higher than the consensus estimate, which would also impact the total return over the next year. By and large, though, the calculus looks fairly balanced, with the one very big assumption that inflation, and therefore interest rates, do not blow out to the upside in the months ahead. If so, all bets would be off.
We have argued for quality: strong balance sheets, defensible economic moats, highly visible earnings growth, and strong management. These are the qualities of companies that prove resilient in bear markets. Given its continued dependence on low inflation and interest rates and high relative valuations, this bull market demands the same focus on quality. Companies who have not invested wisely, been profligate in the assumption of debt, or don’t have the ability to offset rising input costs through price increases could be punished as interest rates and inflation rise. Until we gain more clarity on the trajectory of interest rates, count us among the cautious.