S&P 500 Fair Value, Inflation Expectations

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S&P 500 Fair Value, Inflation Expectations

Three “Data” topics today:

#1: What is fair value for the S&P 500 if 10-year Treasury yields go to 2 – 3 percent? Our answer, based on recent historical data:

  • 10-years reliably yielded 2 – 3 percent from 2016 – 2019.
  • S&P 500 valuations during that period were as low at 14x (during the December 2018 meltdown) and as high as 19x (just before the start of the pandemic).
  • We will use a valuation range of 17-18x forward earnings – slightly higher than 16.5x average from the prior point – for 2 reasons. First is the old “Rule of 20” rubric, which says forward PE multiples plus 10-year yields should equal 20. Second, US corporate earnings and free cash flow remain robust and merit a strong valuation.

The other part of this analysis is estimating what the S&P 500 can earn this year:

  • Wall Street analysts’ estimates bubble up to a $223/share number for 2022 earnings.
  • We are somewhat more optimistic. The S&P 500 earned $54/share in Q3 2021, which annualizes to $216/share. Given continued economic growth and some modest benefit from net inflation, we think the companies of the S&P can earn 12 percent more in 2022, which we round down to $240/share.

Those two points leave us with these calculations:

  • Using the low end of the PE range (17x) and the Street’s conservative $223/share, we get an S&P fair value of 3,800 (3,791, to be precise).
  • Using the high end of the PE range (18x) and our $240/share, we get to 4,320.

Both estimates are well below where the S&P 500 trades today: the best case is still 7 percent below today’s close and the worst case is 19 percent lower. No, we’re not making a market call based on 4th grade math and Wall Street earnings estimates. But … The fact that one can put perfectly reasonable valuation assumptions and optimistic operating scenarios into a widely used framework and end up with no upside for stocks tells us:

  • US large caps don’t entirely believe 10-year yields are going to +2 percent and staying there for years to come.
  • Even our $240/share estimate for 2022 earnings may be lower than the market expects.

Takeaway: those two points – rates and earnings – work in tandem, meaning it’s OK for SU large cap stocks if yields go to +2 percent as long as earnings are better than $240/share. That is the tension underlying current market volatility at present and, we believe, a central theme for the entire year to come.

#2: Is US large cap Tech washed out enough to buy here? We answer questions like that by looking a how a given sector or asset class historically trades over a medium-term window like 50 trading days (just over 2 calendar months). This approach works well for us and allowed us to make some big calls last year like avoiding US small caps after their historic 5-sigma run at the start of 2021.

Here’s the math for large cap Tech (using the XLK exchange traded fund as a proxy). As a reminder, this does not include Amazon or Tesla (both in Consumer Discretionary) or Google and Facebook (both in Communication Services).

  • Over the last 5 years Tech has averaged a positive 5.2 percent 50-day price return. The standard deviation of these returns is 7.6 points, so you’d expect to see Tech return anywhere from -2.4 percent to +12.9 percent over a 50-day holding period without thinking it is anything unusual.
  • As of today’s close, Tech has had a +3.2 percent return over the last 50 days.
  • You might be surprised to see that Tech is still in the black even after its recent drubbing …
  • … What probably won’t surprise you is that it was significantly overbought in December, with a 13-17 percent trailing 50-day return for much of the month. That was more than one standard deviation from the long run mean noted above.

Takeaway: the math says Tech is marginally OK to buy here, but we still recommend an “equal weight” rather than an “over weight” for the group. Yes, it has underperformed its usual 50-day return (+3.2 pct vs. +5.2 pct), but that difference is still well within one standard deviation (7.6 points). Against the current backdrop of cyclical rotation and higher interest rates, we want to see Tech underperform by at least one standard deviation. We aren’t there yet.

#3: The New York Fed’s latest Survey of Consumer Expectations was out today, and it gave Fed Chair Powell one small bit of good news going into his renomination hearing tomorrow. The graph below shows US consumers’ 1- and 3-year forward inflation expectations, the most closely watched data series from the NY Fed survey.

As highlighted, consumers’ inflation expectations did not rise in December; rather, they stayed pat at 4 percent (3-year forecast) and 6 percent (1-year forecast). In fact, the 3-year forecast is down from 4.2 percent in September and October 2021.

Why have inflation expectations stopped increasing, at least for now? The simple answer is that consumers were slightly less worried about gasoline and food inflation in December. We’ve included a link to the full Fed survey results below, and these show that survey takers downgraded their expectations from 9 percent/year inflation for each category in November to 6-8 percent in December. They do expect other categories to see slightly more inflation, hence the overall flat December comp to November.

Takeaway: Chair Powell mentions “survey-based measures” of future expected inflation as often “market-based measures”, so seeing the NY Fed survey flatten out is good news. Expect to hear him mention it tomorrow, even if the overall tenor of his comments recognizes inflation as a risk to consumers. As noted in the chart above, it was just 2 years ago (pretty much to the day) that inflation expectations were just 2.5 percent.

Sources:

NY Fed Survey of Consumer Expectations: https://www.newyorkfed.org/microeconomics/sce#/