The recent stock market pullback may serve as a starting point for the next leg higher in the S&P 500 (SPY). It may result in a strong rally to follow, helping to push the index to around 3,200.
Earnings for the S&P 500 are expected to grow in 2019 and 2020, and based on that growth the index is currently trading an earnings multiple that's below its historical average when looking one year forward. Even the Fed's recent move to an easier monetary policy will keep interest rates low and help to push for further equity market multiple expansion.
The Economy is Outperforming
The economy in the US has exceeded the majority of investors’ expectations this year based on prior consensus estimates, with US GDP growing at 3.2%. Should the current pace of growth continue GDP could grow a much faster pace than what many expect.
According to data from S&P Dow Jones Indices, earnings for 2019 are expected to rise by about 9% to $164.89 per share. That's down about 3.6% since the beginning of the year when they stood at $171.74. Meanwhile, earnings are expected to rise an additional 12.5% in 2020 to $185.52, which is down by 4% from $193.00 at the start of the year. But it leaves the S&P 500 trading at roughly 15.2 times 2020 earnings estimates.
Historically I went back using the data from S&P Dow Jones and calculated that on average the S&P 500 trades at about 17.5 times its one-year forward earnings. Additionally, in 2017 and 2018, the S&P 500 on average traded at about 17 times its one-year forward earnings. Again, it would suggest that the S&P 500 is currently trading at a significant discount to its historical average.
In fact, should the S&P 500 rise to that historical average it would suggest that index trades up to approximately 3150 in 2019. That would be a gain of about 11% from the S&P 500's current level of 2835 on May 10.
There is, of course, the possibility that earnings continue to fall, but for the S&P 500 to reach a one-year forward PE ratio of 17 from its current level, the earnings estimates would need to fall to $166 per share for 2020, a decline of 10% from the current forecast. Yes, not impossible, but seems unlikely should the US economy continue to grow at the steady pace set out by the first quarter GDP growth of 3.2%.
Even if earnings estimates fall an additional 5% from their current levels for next year, to around $176 per share, at 17 times earnings, the S&P 500 will trade at roughly 3,000.
What About the Trade War?
Can the trade war knock that much off earnings estimates going forward? At this point, it may be tough to say. According to an article in MarketWatch, some estimate that it will knock only 0.3% off US gross domestic product in 2020. That doesn't sound like much, and considering the US has a real GDP of $18.7 trillion, it amounts to less than $60 billion. It certainly doesn't feel like much. Consider that this week alone Apple's (AAPL) market cap has fallen by almost $85 billion from around $975 billion to $893 billion.
From a technical standpoint, the S&P 500 is entering a very critical region that suggests a line in the sand in a zone between 2,818 and 2,836. The support region goes back to the middle of October when the S&P 500 was falling and acting as a significant level of resistance on multiple occasions. The same area served as resistance on the way higher in February. This region of support should offer the index a place to bounce and potentially to serve as a starting point for the indexes to advance to the next leg higher.
What Do Other Markets Think?
The bond market, the dollar, and oil have had a pretty muted reaction to the trade worries. There has been nearly no flight to safety during the equity market sell-off. The dollar index has dropped to 97.25 from 97.50 on May 3. Meanwhile, 10-year Treasuries are trading at 2.44%, down from 2.52% on May 3. Even oil, a highly volatile commodity tied to global growth, and rising tensions with Iran, has hardly reacted, as the chart below shows.
The market can stay in an irrational state for some time, and it's hard to know precisely when the volatility will die down, and that remains one of the most significant risk for investors. Additionally, it's unclear just how long the trade battle can last or how far it can escalate. Meanwhile, the technical chart would suggest that if the S&P 500 falls below a level of support at 2812, the S&P 500 could go on to drop even further, perhaps to as low as 2,720.
Additionally, it's not to say all sectors of the market will perform well. Semiconductor, industrial, and material stocks may suffer should the trade wars continue to rise, especially if those companies rely on China to help in the manufacturing process of their products.
While the market turmoil continues and investors digest the rising trade tensions, the outlook for earnings and the economy continue to be healthy. Should the trade tension ease or the economic impact turns out to minimal as some estimates suggest, this may prove to be a short-term pullback in a long-term bull market.
The focus of Reading the Markets is to find stocks that may rise or fall using fundamental, technical, and options market analysis. Additionally, we search for clues from the broader markets to discover trends and gauge direction.
Michael Kramer relies on his more than 20-year of experience working in the financial industry. 10-years of experience comes as an international and domestic buy-side equity trader at multi-billion long/short investment advisor.
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Disclosure: I am/we are long AAPL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Mott Capital Management, LLC is a registered investment adviser. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Upon request, the advisor will provide a list of all recommendations made during the past twelve months. Past performance is not indicative of future results.