Four topics today:
#1: When does the market finally figure out what the S&P 500 can earn over the next 12 months? The FactSet chart below shows the trailing 1-year history for Wall Street analysts’ aggregate S&P 500 earnings estimate for 2021 (bottom line) and 2022 (top line). Two points on this data:
First, analysts’ earnings expectations for 2021 earnings at the start of this year ($167/share) were way too low. With three quarters in the bag and Q4 expectations very reasonably set, the S&P is going to print a $205/share result for 2021. In other words, 2021 earnings beat the Street by 23 percent. The S&P is up 25 pct YTD, almost exactly in line with this fundamental outperformance.
Second, the Street (and, by extension, markets) expects 2022 to show further improvement in US corporate earnings power. In April 2021, analysts were collectively looking for 2022 earnings to be $205/share. Seven months later, we now know that was the right number but for this – not next – year.
Now, you might well say “Wall Street analysts aren’t always the sharpest tools in the shed”, and fair enough, but:
- Stock prices are, by definition, always set by the marginal investor or trader.
- These are often highly sophisticated hedge funds and market making operations with access to virtually real time data about the US/global economy as well as single stock corporate fundamentals. We’ve seen the sorts of information they use, everything from last week’s US credit card spending to daily satellite imagery and web traffic. It’s profoundly impressive, if not a little scary, how comprehensive it is.
- While retail investors can certainly skew marginal stock prices in meme stocks, it is hard to argue their influence meaningfully affects the US large cap Tech sector or Amazon, Google, Facebook, or even Tesla now that it is a $1 trillion company.
This is, to our thinking, what makes 2021’s S&P 500 performance so remarkable. On the one hand, a 25 percent YTD return and a new high just this past week is easily explained by actual earnings beat expectations by 23 percent. On the other hand, stock markets hard-wired to reflect real-time economic/fundamental data should have forecast and discounted those earnings surprises months ago.
In our view, the reason for this disconnect between a market where prices are set by “Big Data” and persistent earnings surprises is that after tax operating margins (not revenues) have proven unpredictable. In short, they have been far, far above expectations.
We showed you this chart last Sunday, but it merits another look. Year to date, S&P net margins (after tax income divided by revenues) have averaged 12.9 percent, notably higher than the prior peak of 11.6 pct in 2018 (right after US corporate taxes were cut). Yes, analysts are expecting Q4 margins to come down to 11.8 percent. That’s likely too pessimistic, however; would companies still be hiring so aggressively (as October’s Jobs Report showed) if they expected near term margin contraction of this magnitude? No. They would not.
Takeaway: the companies of the S&P 500 have shown remarkable profitability this year, and US equities will stop rallying only when 1) forward year earnings estimates fully reflect that fact, or 2) margins contract in such a way as to convince markets that 2021 was an unsustainable peak. Margins tend to rise during economic expansions because corporate cost structures always have a “fixed costs” component. On top of that, inflation, as we’ve described in several recent notes, helps corporate profitability since businesses pass along price increases. Those two facts support the idea that margins can at least hold steady (if not increase slightly) in 2022. No wonder the S&P 500 still looks unstoppable.
#2: As a cross-check on this “best of all possible worlds” scenario when it comes to profit margins, let’s look at US investment grade (IG) and high yield (HY) corporate bond spreads over Treasuries. If margins really are sustainable at current levels, you’d expect to see spreads at record lows versus the last 5 years. Less cash flow risk should equal lower risk premia for this asset class, after all.
This chart shows IG and HY spreads over Treasuries over the last 5 years (the same timeframe as the previous chart) along with our notes on where these bottomed pre-pandemic and where they have been in 2021:
Takeaway: corporate bond markets are only weakly endorsing the idea that current record-high profit margins are sustainable for the next 4 – 10 years (the effective duration of HY/IG bond indices, respectively). Investment grade spreads have been trending around the last cycle’s low point (86 – 94 recently, 2010: 90 bp). High yield spreads are currently in line with the last cycle’s nadir (322 bps then, 319 bps now and 302 bp low this year). Bond investors are, of course, a more cautious lot than equity market participants. They also don’t get paid for upside earnings surprises. Their reluctance to believe corporate profit margins will remain robust is therefore understandable. There’s little upside to being right in that assumption and plenty of downside if they are wrong.
#3: With year-end just around the corner, we were looking earlier today at equity market returns around the world and thinking about what’s caused this disparity:
- S&P 500: +25.1 percent YTD
- Russell 2000: +18.7 percent YTD
- MSCI EAFE (non-US developed economies): +10.2 pct YTD
- MSCI Europe: +14.3 pct YTD
- MSCI Emerging Markets: -1.5 pct YTD
One answer is US Big Tech, which is heavily present in the S&P 500 but obviously not in any of the other indices. Here is our back of the envelope performance attribution math for each name, YTD through Friday:
- Microsoft (+54 percent YTD): +3.2 points of S&P 500 performance
- Apple (+21 pct YTD): +1.3 points
- Amazon (+13 pct YTD): +0.5 points (note: the only lackluster name here)
- Google (+70 pct YTD): +2.6 points
- Tesla (+61 pct YTD): +1.2 points
- Facebook (+26 pct): +2.1 points
- Total: 10.9 points
Takeaway: without these 6 names, the S&P 500 is up 14.2 percent on the year, less than the Russell (+18.7 pct), largely in line with MSCI Europe (14.3 pct), but still well ahead of Emerging Markets (-1.5 pct). US Big Tech is essentially its own asset class. Owning it has been essential to global equity portfolio outperformance.
#4: US used vehicle prices are, for lack of a better word, insane. Their importance goes well beyond the car dealer’s lot. Used cars and truck prices have factored heavily in rising US Consumer Price Index inflation this year, and car auction company Manheim’s latest Used Vehicle Value Index says their contribution has not yet peaked.
Here is the Manheim data for November (+45 percent year over year), as compared to the prior 6 months. By this measure, US used vehicle inflation had been trending lower from May 2021 (+48 percent) through August (+19 pct). It has been reaccelerating since, first to September’s 27 percent comp and then to October’s 38 pct rate. And now November …
Takeaway: while used vehicles are only a small part of the CPI (3.3 percent of headline, 4.2 pct of core), rising prices in this category have been a very visible sign of persistent inflation pressures in the US economy. Manheim’s latest reading shows we have not yet turned the corner.
Also worth a mention, just because the numbers border on the ridiculous: using Manheim’s data, the average late model US used car or truck is 69 percent more expensive than 2 years ago. The S&P 500 is “only” 51 percent higher over the last 24 months, and that’s because (as noted in Point #1) corporate profit margins are at record highs. A used car does exactly the same thing as it did 2 years ago: get you from location A to location B.
Manheim Used Vehicle Price Index: https://publish.manheim.com/en/services/consulting/used-vehicle-value-index.html