by Jason Norris, CFA
Executive Vice President, Equity Research and Portfolio Management
The Writing on the Wall
“Tell me where earnings are going, and I’ll tell you where the markets are going” is a common phrase you’ve heard from us over the years. There are two factors that determine how the equity markets will perform: earnings growth and how much investors are willing to pay for those earnings (the price-to-earnings multiple or P/E). The long-term average P/E multiple on the S&P 500 is 15-17x a dollar of earnings. At current market levels, the P/E is 21x, which is at the high-end of its historical range.
There are a variety of factors that go into the P/E multiple: growth of earnings, risk of that growth, interest rates, inflation, etc. Historically, with strong earnings growth and low inflation/interest rates, investors are willing to pay more for a dollar of earnings. However, when earnings growth is slowing or negative and/or interest rates are high, investors will pay less for that future earnings stream. When applying the P/E to earnings, the most common metric used is the estimated “next 12 months.”
The chart below highlights forward earnings for the S&P 500 (the market) as well as the price. While the correlation may not be 1.0, it is very positive.
The long-term data supports what we have seen the last 12 months; that as earnings continue to grow, stocks continue to move higher. Looking back one year ago, earnings were estimated to be ~$140; one year later, earnings are estimated to be $190. Therefore, with earnings growing over 35 percent, it makes sense for stocks to deliver the returns we’ve seen over the last 12 months (see chart below).
All Ends Well
We had expected growth for the first quarter to be fairly healthy; however, companies have delivered meaningfully above those lofty expectations. With 90 percent of the S&P 500 reporting earnings thus far, 86 percent of companies have beaten expectations with an average of 22 percent to the upside. This is resulting in potential year over year first quarter growth of 50 percent. Heading into earnings season, analysts were expecting 20 percent growth. We expect this momentum to continue throughout the year, which will be a tailwind for equities.
When we look toward 2022, we see some potential headwinds in the form of a corporate tax increase and a lack of fiscal stimulus - so we expect growth to slow. Current expectations are for 12-15 percent growth; a corporate tax increase may cut that rate down to 8-to-10 percent. However, that reduced growth rate is still slightly above the long-term average for profit growth, therefore, while it may dampen the equity upside, we do not expect it to cap it.
The Other Side
Twelve months ago, there were over 23 million people out of work due to the economic impact of the onset of the COVID pandemic. As vaccine distribution and government stimulus worked its way throughout the United States, we are seeing a meaningful improvement in the economic outlook. This morning, the Bureau of Labor reported an unemployment rate of 6.1 percent, with 9.8 million people unemployed. The hardest hit sector of the pandemic, leisure and hospitality, saw strong job gains of 331,000. While the overall job gains in April, 266,000, were a disappointment, the economy is still on the right trajectory. However, this slowdown in job gains highlights the fact that businesses are having trouble finding labor for their positions.
Week in Review and Our Takeaways
Stocks ended the week up slightly; however, internal market indicators were fairly diverse. Commodity-sensitive sectors finished up over 4 percent while technology shares fell 2 percent as investors sold “growth” and bought “value” stocks
Even after a 13 percent increase in equities this year, stocks are 5 percent cheaper than when they started 2021