Two Data items today:
#1: How much higher can S&P 500 earnings estimates go? Not to oversimplify, but this is essentially the only question that matters to US stocks and, by extension, global equities. The American economy, by dint of everything from consumer savings levels to vaccination rates, is best positioned to show further growth. The rest of the world should continue to recover, but not likely at the same rate as the US. That makes the S&P the valuation/sentiment “umbrella” for non-US equities.
This is the simplest way to consider this question: quarterly S&P earnings pre- and post- pandemic (chart courtesy of FactSet’s weekly Earnings Insight report):
Three points on this:
- It’s clear to us that numbers for Q2 2021 – Q1 2022 are too low. They average to $49.27/share, essentially the same as Q1 2021’s actual $49.06. Analysts have been cautious about raising numbers given a lack of earnings guidance and macro uncertainties, and that’s fair enough. But expecting zero growth from Q1 strikes us as overly pessimistic.
- Earnings leverage – how much more quickly earnings grow relative to revenues – is the key issue to consider. FactSet’s data for Q3 2021 is telling on this point. Wall Street analysts are expecting 13 percent sales growth and 26 percent earnings growth versus Q3 2020. That implies 2:1 leverage, but so far in Q2 we’re seeing almost 5:1 aggregate leverage on earnings surprises (19 percentage points of earnings upside on 4 points of revenue upside).
- The bottom line is that sustainable earning power on the S&P 500 should be more like $55/share over the next 4 quarters, or $220/share if the leverage math works out as we think it will.
More important than just the DataTrek view is that markets clearly believe this math. The S&P is trading for 20x that $225/share number, so if one can’t defend that sort of EPS estimate than the inevitable conclusion is that US large cap stocks are overvalued.
The good news is that estimates continue to creep higher, as this FactSet chart of 2021 (lower line) and 2022 (upper line) of Wall Street analysts’ earnings numbers show. Their best guess for 2022 ($214/share) is below our $225/share estimate, but the trendline is definitely moving in the right direction.
Takeaway/final thought: remember that pre-pandemic the S&P was earning $163/share (2019 actual), so post-pandemic earnings power of $225/share is 38 percent better than that, and the index is only up 31 percent from its February 2020 highs. That’s a brute force analysis, but it does neatly explain why US large caps remain resilient.
#2: Ahead of this week’s FOMC meeting, what are Fed Funds Futures expecting for Fed rate policy? No surprise, but the CME FedWatch tool (link below), which uses current Futures pricing to calculate the odds of a policy change, says the probability of a 2021 rate increase is zero.
Looking out to December 2022, here are the current FedWatch probabilities:
Three brief points on this data:
- Futures give slightly better than 50:50 odds of a 2022 rate increase (currently 55 pct)
- This is down from last week when the odds of a rate hike where 68 percent, and versus a month ago when the odds were 74 pct.
- Declining odds of 2 rate increases in 2022 are the reason for most of this shift. The probability of that outcome has gone from 25 percent a month ago to 21 pct a week ago to 14 pct now.
Takeaway: this is a near-ideal setup for the Fed and Chair Powell going into this week’s FOMC meeting. Worries that the Fed may be behind the inflationary curve have abated over the last month, as evidenced by the lower probabilities of 2 rate hikes in 2022. Even-money odds on 1 hike next year allows Powell room to give an upbeat assessment of the US economy without spooking markets into thinking he is reconsidering the date of “lift off”.