Three “Data” items today:
Topic #1: Today’s US equity market rout was caused by disappointing earnings over the last 2 days at major retailers like Walmart and Target, which supports our ongoing belief that market expectations for S&P 500 earnings are still too high. Looking through the WMT and TGT press releases, the following items caught our eye:
- Walmart reduced its Q2 earnings per share guidance to “flat to up slightly” from “increase low to mid-single digits” as compared to last year. It also cut its whole-year 2023FY EPS guidance to down 1 percent growth from a mid-single digit percentage increase versus prior year. Worth noting: WMT raised its revenue guidance for the year, from 3 percent to 4 percent growth.
- Target gave Q2 operating margin guidance of “in a wide range” centered around Q1’s 5.3 percent. Margins in last year’s Q1 were 9.8 percent. The company’s guidance for 2023FY operating margins is much lower: just 6 percent.
We show you this FactSet chart of trailing/actual and projected S&P 500 EPS estimates almost every Sunday, but it is worth looking at again today. It shows that S&P 500 earnings had been steadily improving from their pandemic-hit lows in 2020 and EPS the last 2 quarters (Q421 and Q122) hit an average of $54.65/share. That is a record, and 35 percent better than the 2018 – 2019 average quarterly earnings run rate of $40.59/share.
The problem lies in the Q3 – Q4 2021 estimates, which average to $60/share in S&P 500 EPS. That implies 10 percent earnings growth from the Q4-Q1 run rate. Yes, there is some seasonality to S&P earnings, but it’s more like 3 percent through a year – not 10 pct. And… That assumes a stable operating environment, not one with the sorts of inflation and supply chain pressures so vividly present in the Walmart and Target earnings reports.
As for what all this means to stock prices:
- If the S&P earns $220/share in 2022 (4x the Q4-Q1 run rate, rounded up), the index is trading for 17.8x this year’s earnings based on today’s close.
- That 17.8x multiple is fairly close to what you’d expect using the old Wall Street “rule of 20”, which says inflation expectations plus the S&P PE ratio equals 20 over time. Current 10-year inflation expectations are 2.7 percent, making 17.3x notional “fair value”.
- If you want to be precise about this admittedly rough analysis, the S&P should trade to 3,806 (17.3 times $220/share). That is 3 percent below today’s close.
The bottom line is that, broadly speaking, the S&P 500 now discounts no further growth in earnings power beyond what we’ve seen in Q4/Q1, but that does lead to the harder question of “where does the index go if markets start to think earnings are set to decline?” After today, it is a fair point to consider. Some simple math using the same 17.3x multiple outlined above:
- Earnings decline 5 percent (to $209/share): S&P at 3,616, down 8 pct from today
- Earnings decline 10 percent (to $198/share): S&P at 3,425, down 13 pct
- Earnings decline 15 percent (to $187/share): S&P at 3,235, down 18 pct
Before we wrap up, keep in mind that even the worst scenario listed above ($187/share) still has the S&P 500 earning 15 percent more than 2018 – 2019’s average of $162.35/share. It is not a “disaster” scenario, and nor does it even match the typical 25 percent decline in S&P 500 profits during a recession. That would be $164/share, or almost exactly what the index earned in each of the 2 years before the pandemic.
Takeaway: markets have given up on the idea that S&P earnings will grow from here but have not yet discounted any chance they will decline. We are not inclined to think profits will erode considerably, but we also know asset prices swing over the short term on sentiment rather than math.
We remain cautious on stocks and are waiting for either a 36-44 reading on the CBOE VIX Index or the second and subsequent down 5 percent days to get more positive. The latter is our framework for investing in crisis markets. It looked like we might hit the first down 5 percent S&P day today, but for better or worse it did not happen. Such an event, however, remains a distinct possibility.