Two “Data” items today:
Topic #1: S&P 500 earnings growth when the Federal Reserve is raising interest rates. In last night’s report we noted that the crux of the positive case for US stocks is strong corporate earnings. But can S&P companies continue to grow their bottom lines if the Fed starts to hike rates?
Here is what the historical record has to say on that question:
1994 – 1995 rate cycle
- Fed Funds went from 3.0 percent to 6.0 pct, starting in February 1994 and ending in February 1995. This tightening cycle started with 3 25 basis point increases, then 2 50 bp bumps, a 75 bp increase, and finished with a 50 bp increase.
- The S&P 500 had earned $26.90/share in 1993.
- It then went on to earn $31.75/share in 1994 (+18 percent) and $37.70/share in 1995 (+40 pct vs. 1993, +19 pct vs. 1994). Earnings continued to grow in 1996 ($40.63/share, +8 pct from 1995).
1999 – 2000 rate cycle
- Fed Funds went from 4.75 percent to 6.5 pct from June 1999 to May 2000. There were 5 25 basis point increases to start, and a 50 bp bump at the end.
- The S&P 500 had earned $44.27/share in 1998.
- It earned $51.68/share in 1999 (+17 percent) and $56.13/share in 2000 (+27 pct from 1998, +9 pct from 1999). Earnings in 2001 were down ($38.85/share) due to the economic slowdown and macro uncertainty caused by the 9-11 terror attacks.
2004 – 2006 rate cycle
- Fed Funds went from 1.00 percent to 5.25 pct from June 2004 to June 2006. There was a total of 17 rate increases across this period, each 25 basis points.
- The S&P had earned $54.69/share in 2003.
- It earned $67.68/share in 2004 (+24 percent) and $76.45/share in 2005 (+40 pct from 2003, +13 pct from 2004). Earnings continued to increase in 2006 to $87.72/share (+15 pct vs. 2005) but dropped in 2007 to $82.54/share as the housing bubble started to burst and financial conditions worsened.
2015 – 2018 rate cycle
- This was the slowest rate cycle in living memory, with Fed Funds going from 0 – 25 basis points to 2.25 – 2.50 pct from December 2015 to December 2018.
- The S&P 500 had earned $113.01/share in 2014.
- Earnings fell in 2015, to $100.15/share (-11 percent) and did not fully recover in 2016 ($106.26/share, -6 pct from 2014), primarily due to lower oil prices. The S&P then went on to earn $124.51/share in 2017 (+10 pct vs 2014), $151.60/share in 2018 (+34 pct vs 2014) and $157.12/share in 2019 (+39 pct vs 2014).
Takeaway (1): there is no evidence in the historical record back to 1990 for Fed rate cycles causing a decline in US corporate earnings. The 2015 – 2018 example, where there is a correlation, was due to lower oil prices hitting Energy sector earnings. Aside from that, earnings have always increased as the Fed raises rates.
Takeaway (2): it’s not enough to say “earnings will increase in 2022” to be bullish here. An S&P 500 at 4,500 requires a specific amount of earnings growth to justify that level, let alone defend a positive view on US large caps. Specifically:
- Wall Street is looking for $225/share in S&P earnings this year. That is 9 percent higher than 2021’s $206/share, so it fits the historical pattern we’ve described today.
- The S&P 500 is trading at 20x that 2022 expected earnings number, uncomfortably high in a rising rate environment.
- Markets are clearly signaling that they believe the Street’s number is too low, and $240 – $250/share is the more likely outcome (midpoint PE of 18x). That implies 17 – 21 percent earnings growth in 2022, which resembles the improvement we’ve seen in prior rate cycles.
Bottom line: as much as the market narrative may be entirely fixated by Fed rate policy right now, US corporate earnings have a proven track record of delivering strong growth during tightening cycles.
Topic #2: The recent performance of US small caps (Russell 2000) and what that says about the near future. The Russell has had a rough start to 2022, down almost 10 percent, and it has also severely lagged the S&P 500 over the last 12 months (-11 pct vs +15 pct).
That got us to wondering if the recent swoon was big enough to make the Russell worth owning here for a trade. We ran the 50-day returns for the index back to 2005, and here is what we found:
- Since 2005, the Russell has averaged a 1.9 percent price return over any 50-day period. The standard deviation of those returns is unsurprisingly large: 9.5 percentage points.
- That means we should expect the Russell to return somewhere between +21 percent and -17 percent over any 50-day period, using 2 standard deviations as a reasonable band of possible returns.
- The Russell hit the lower end of that band during the late January selloff, with a -18.1 percent trailing 50-day return on January 26th, 2022.
- It has since started to rebound, up 6 percent off the January 27th lows.
You know our mantra about not buying new 52-week lows, but the Russell’s recent rebound and the statistical fact that we hit a 2-standard deviation move makes it worth considering what might happen next. Here is a list of every time the Russell was first down 17 percent or more over a 50-day stretch since 2005 and the forward 50-day returns from that date:
- March 10th, 2008: -19.2 percent. 50 days later: +14.2 pct
- October 7th, 2008: -19.7 pct. 50 days later: -19.0 pct
- March 2nd, 2009: -23.8 pct. 50 days later: +29.0 pct
- July 2nd, 2010: -18.4 pct. 50 days later: +7.9 pct
- August 8th, 2011: -21.7 pct. 50 days later: -3.6 pct
- February 8th, 2016: -18.5 pct. 50 days later: +15.7 pct
- December 19, 2018: -17.2 pct. 50 days later: +14.4 pct
- March 9th, 2020: -21.7 pct. 50 days later: -8.0 pct
Takeaway: the average 50-day forward return for these events is 6.3 percent, which is right on top of the 5.9 percent gain we’ve had off the January 27th lows. Yes, there are instances where the Russell continued to move higher (2008, 2009, 2016, and 2018). But the list above shows that is not a lock. The bottom line here is that the Russell has done what it’s “supposed” to do after an outsized drop. By the math, there’s not much further upside over the near term.