The biggest problem for the S&P 5000 target is underlying earnings. There is an obvious correlation between economic growth and corporate earnings. Such is because over the long term the economy is what generates corporate revenues. While analysts ramped up earnings expectations following the massive liquidity injections from the Government, the payback is coming.
The first problem with Wall Street analysis is several:
- Historically, earnings estimates are roughly 30% higher than what turns out to be reality.
- As reporting dates approach, analysts revise down estimates below reported levels (assuring a high beat rate), and
- Analysts are never held accountable to their original estimates.
Given the lack of accountability, it is not surprising analysts are always overly optimistic in their initial estimates which gives them plenty of room to downgrade in the future.
However, there is roughly a 90% correlation between the stock market and GAAP earnings growth. Therefore, if earnings do decline, as profit expectations fall, then the S&P will have a more difficult time hitting a high target.
Furthermore, the current gap between corporate profits and the market has historically not ended well for investors.
The problem currently is even with the estimated increase in earnings, the QE-driven price increase keeps valuations extended well above historical ranges.
While that statement comes with the caveat that “valuations are terrible market timing metrics,” they do imply lofty expectations are likely to be disappointed.
Today, most companies report “operating” earnings which obfuscate profitability by excluding all the “bad stuff.”
The following table shows the expectations for reported earnings growth:
- 2020 (actual) = $94.13 / share
- 2021 (estimate) = $185.49 (Increase of 97% over 2020)
- 2022 (estimate) = $200.62 (Increase of 113% over 2020)
The chart below uses these earnings estimates and assumes NO price increase for the S&P 500 through 2022. Such would reduce valuations from 41x earnings in 2020 to roughly 22x earnings in 2022. (That valuation level remains near previous bull market peak valuations.)
However, if analysts are correct and the market hits 5000, valuations remain elevated. Instead of valuations declining, the increase in price keeps valuations hovering near 25x earnings.
Given that markets are already trading well above historical valuation ranges, such suggests that outcomes will likely not be as “bullish” as many currently expect.
Historically, price has usually remained below the top of the normal value range (red line); however, since about 1998, it has not been uncommon for price to exceed normal overvalue levels, sometimes by a lot. The market has been mostly overvalued since 1992, and it has not been undervalued since 1984. We could say that this is the ‘new normal,’ except that it isn’t normal by GAAP (Generally Accepted Accounting Principles) standards.
We don’t disagree the S&P 500 could well hit a target of 5000. But, let us be honest about the reasons why:
- $120 billion a month in liquidity (QE)
- MMT – Modern Monetary Theory
- Zero interest rates,
- Congress passing Trillions in spending stimulus
- A substantial amount of speculative market fervor.
Such does not preclude a “round-trip” ticket in the future.
Throughout history, overvaluations of markets have never been resolved by earnings catching up with the price. Secondly, the two-fold problem of the temporary nature of the stimulus and inflation leaves the market vulnerable to a downward shift in earnings expectations over the next few quarters. As noted, Wall Street has ratcheted up expectations to try and justify current prices.
While monetary interventions allow market participants to ignore the reality of the economic ties to the market, such does not preclude hair-raising volatility and significant declines, as we saw in March 2020.
More importantly, if the Fed backs off, whether by its design or due to inflation, slower economic growth, or massive debt overhead, rich valuations will matter.
The risk of disappointment is high.
Now let’s look at GDP expansions. I want you to look at the periods between recessions, what business cycle theorists call the “expansion phase.” Looking only at those (omitting the recession quarters), here is the average quarterly GDP (annualized rates) for the last three expansions.
- 1991–2001: 3.6%
- 2001–2007: 2.8%
- 2009–2019: 2.3%
The last three expansion/recovery phases were each weaker than the last. Maybe that’s coincidence, but it matches a lot of other data showing “growth” isn’t what it used to be.
Hindsight is always 20/20. It’s easy to look back and say governments overreacted in the initial COVID crisis, both with economically harmful protective measures and added spending to mitigate that harm, but there was much we didn’t know at the time. I think they were right to err on the side of caution. The first massive stimulus was necessary; subsequent rounds were more questionable.
Necessary or not, the spending was truly staggering. Here’s a chart comparing the inflation-adjusted per-capita spending with two previous crises. In fiscal terms, we just lived through the equivalent of two New Deals. And instead of 10 years, it happened in less than two.
The scale and speed of this spending explains much, if not most, of the recent GDP growth. Putting an extra $14 trillion on top of normal government spending into a $20 trillion economy is a massive sugar high. It wasn’t a free lunch by any means; the national debt went up accordingly. But it still had a short-term stimulus effect.
The stimulus effect is now ending. The last round of $1,400 payments is either spent or banked. The extended and enhanced unemployment benefits ended this week in the states that hadn’t already canceled them. The small businesses who received payroll support are reaching the end of their rope.
Yes, Congress is considering a pair of infrastructure bills whose price tags, if they pass in the proposed form, will outweigh the prior COVID bills. But passage is increasingly dubious. (More below.) Even if they do, the spending will be spread over many years. It won’t come close to replacing the other programs that have ended, or will end soon.
For all intents and purposes, without more stimulus the economy is back on its own as the fourth quarter approaches—and basically where it was in late 2019. It may even be worse, considering changes to the workforce. Millions have died, become disabled, retired early, or are retraining for career changes. While this may be long-term positive in some cases, it’s not necessarily positive for the next quarter’s GDP.
One serious downside risk is inflation. Economists talk about “nominal” and “real” GDP, the latter of which is adjusted for inflation. Higher inflation pushes real GDP lower. An economy showing 4% nominal growth and 1% inflation would have 3% real growth. Not so bad. But if nominal growth stays exactly the same but inflation rises to 4%, real growth would be 0%.
It gets worse. If nominal growth falls just a little, say from 4% to 3%, then a 4% inflation rate would push real growth down to -1% recession territory. A little bit of inflation can amplify a mild setback into a serious one in real terms.
I mentioned the 4% inflation rate because that is exactly where we are when we look at PCE (Personal Consumption Expenditures) inflation, the Fed’s favorite measure.
I am increasingly concerned that the Fed is toying with inflation and the economy could slow down more than they currently project. They are roughly projecting 2–3%+ growth and slightly above 2% inflation. That would be a very good outcome. I am more worried they are wrong, as they have often been in the past, and we’ll get the worst of both worlds: higher inflation and lower growth—in a word, stagflation.
US Economy
- The August payrolls report was disappointing, with the number of jobs created coming in well below forecasts.
- Many analysts blame the negative surprise on the Delta variant spike.
- But there is more to this story. Labor shortages also contributed to lower hiring last month as the job market continues to tighten.
– Small firms have not had this much difficulty hiring workers in recent history (a record high for this index).
- Automobile sales continue to weaken, with factories cutting output due to supply shortages.
- Heavy truck sales are also slumping despite robust demand.
- Economists have been downgrading their forecasts for the current quarter’s GDP growth.
- Goldman expects growth to remain robust through the middle of next year, driven by pent-up demand. But the bank sees deterioration after that point.
- Fiscal austerity is unlikely to be repeated in future cycles (no matter which party is in charge).
- MRB Partners expects core inflation to end the year near 4%.
- The recent PPI-CPI divergence is not sustainable.
- Back-to-school retail traffic has been robust.
- In another sign of tightening labor market conditions, job openings hit a record high in July.
- There are now five job openings for every four unemployed Americans.
- Home price appreciation should slow sharply in the months ahead, according to CoreLogic.
- Tappable equity in homeowners’ properties reached a record high.
- House flipping has become challenging amid tight inventories.
- Container shipping costs (globally):
- Costs to ship cars:
- There appears to be ample liquidity in the US economy, which reduces the risk of a near-term recession.
- The Evercore ISI business activity indicator has been rolling over.
Market Data
- All sectors except energy appear to be overbought relative to their 50-day moving averages.
- It has been a record-breaking rally off the lows, with historic patterns calling for flattening from here.
- Historically, given the current valuations, returns over the next 12 months are expected to be poor.
- The following graph and commentary from GMO, show that over the last year corporations took advantage of higher share prices. Interestingly, IPO issuance is currently running at the same pace as the market peak in 2000. Massive issuance from existing stocks is largely responsible for the big difference between total issuance today versus 2000.
– Michael Lebowitz
- The Bear Market Probability Model has risen to a high level at the same time that the Macro Index Model has deteriorated. This combination has almost invariably led to lower stock prices in the months ahead.
- The Nasdaq 100 Index is entering a seasonally weak period.
- Cyclically-adjusted P/E measures suggest that stocks are massively overvalued,
Thought of the Week & Picture of the Week
“May we never forget”
All content is the opinion of Brian J. Decker
