The S&P 500's recent gains have come despite nothing changing on a multitude of levels. In some cases, the environment for stocks has grown worse. The Nasdaq 100 has rebounded off a very sharp March decline, while the Small Cap Russell 2000 has struggled to bounce back. Everything we have tracked since before the beginning of March, like rising yields, valuations, the dollar, and inflation expectations, has not changed.
Why the market has rallied, it appears to be due to quarterly rebalancing, which has now passed, and monthly inflows. The first day of every month except January has seen the S&P 500 rise by 1% or more since November. At the very least, every month since June, except for January, has had a positive first day. But the first few days of the month are not always a predictor of where the rest of the month of goes.
The job report on Friday was much worse in the bull case than it might seem. Fed Futures are now pricing in as many as one rate hike by the September 2022 FOMC meeting and as many as two rate hikes by the December 2023 FOMC meeting. That's a big change in the positioning of the market just since the middle of February.
To this point, the Fed called the bond markets bluff, and the bond market blinked. With rates on the long end of the curve settling around 1.7% on the 10-year. However, we have seen a significant move higher in yields in the middle of the curve, with the 7-year note rising the greatest amount, followed by the 10-year, the 5-year, and the 30-year. At this point, rising rates do not seem to be easing by much, and the FOMC minutes on Wednesday and PPI could present another opportunity for rates to reposition again. Still, the current position and the risk the bond market poses haven't eased.
At this point, the market appears to be suggesting that the Fed is likely to act sooner than what has been indicated by the Fed. If this is the case, then the equity market is not priced correctly for a monetary policy change. The equity market is still trading at very high earnings multiples, and the growth forecast does not justify the valuation we see across the broader equity market.
If the economy is returning to some form of normalcy, then it only seems appropriate for rates to rise in the middle to the long end of the curve. It has been the steepening of the yield curve that has created the biggest problems for equity prices in the past. To this point, the equity market has been unfazed by the curve's big advance.
That could literally change anything, especially with the S&P 500 trading at 18.5 times 2023 earnings estimates of $220.15 per share. That's a very high multiple on a historical basis. Since 1985, the S&P 500 has traded on average at 13.2 times two-year forward earnings estimates, with one standard deviation of 3.2, creating a trading range of 10 to 16.4 times two-year forward earnings estimates.
There have only been five periods since 1985 that we have traded above 16.4 times estimates: 1997 through 2002, 2004, twice in 2018, and now.
Even over the past 10 years, the average doesn't change much, rising to 13.9 on average, while the bands narrow to 11.7 and 16.1. It still shows that even in modern times, stocks are not cheap at current levels. An earnings yield chart would reflect the same information in an inverse fashion, which also suggests valuations are steep.
The growth expectations for earnings for 2021 are expected to be strong, especially following 2020's plunge. But those growth rates are expected to slow dramatically in 2022 to just 15.2% and 11.1% in 2023.
With earnings growth slowing that dramatically, it could suggest that multiples going out to 2023 are just way too high. In fact, as we know, earnings estimates typically fall with time, with the exception of 2018, which was the year that the corporate tax cut took effect, helping to boost estimates through the year. If the same trend holds through, and earnings estimates prove to be too high beyond 2021, then the index will have a tough time maintaining its current valuation as well.
At a more modest valuation and one standard deviation from the average, one could argue the S&P 500 is worth around 3,600, while at 13.2 just 2,900. While the low-rate environment on a historical basis is likely to support valuations greater than the historical average, the other big factor is which way earnings estimates will move. Supposing they follow their historical trend lower than one could easily make a case an S&P 500 valuation well below 3,600. Additionally, if a corporate tax hike gets passed, it's also likely to weigh on earnings estimates in the future and most certainly bring those numbers lower.
The market can trade at ridiculous valuations for some time, and when they revert to historical norms, the revision can be rather painful. At its current valuation, the S&P 500 would need to earn more than $253 per share in 2023 to have a PE multiple of 16.1, which is nearly 15% more than estimates. If estimates for 2023 climb another 15% from current levels, one could easily argue that the market deserves to trade at current prices, but given what lies ahead, it seems unlikely.
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