- Earnings growth for the S&P 500 is being pulled forward, and that's depressing future growth rates.
- Additionally, all signs point to higher interest rates in the months ahead.
- Coupled together - the index P/E ratio needs to fall dramatically.
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The edge is getting closer and closer. Despite a really great earnings season, the S&P 500 and the Nasdaq have stopped rising. Tired? Maybe, probably not. It's a message. The market isn't tired - it's telling investors quite loudly that we have seen the best growth rates and that peak growth is now passing. Couple that with rising rates and multiples need to contract, which means valuation needs to come, potentially by more than 20% in the S&P 500.
The S&P 500 has been stuck around 4,150 since the middle of April now. Despite earnings estimates for the index rising significantly from where they stood at the start of the earnings season. Analysts now see S&P 500 earnings climbing to $181.45, from $172.28 on March 31. That's an increase of 5.3% in just five short weeks. Over the same time, the S&P 500 has risen by nearly 5% as well. It leaves the index trading for 23 times 2021 earnings. So, despite earnings estimates rising sharply, the P/E multiple has remained unchanged, that is because S&P 500 has risen right along with it.
Over time, we have discussed how rising interest rates would cause multiple compression, which is what has been happening to growth stocks. But there's something else that can kill the P/E multiple, slowing growth. Even with all of the good news about strong earnings. Future growth is being pulled forward, and that growth is being taken from future years. Lower growth rates imply lower P/E multiples for future years.
Growth for 2021 is now expected at 33.4%, up from 26.7% on March 31. But that has taken away from growth in 2022, with the growth rate slipping to 12.6% from 15.1% over the same time. Meanwhile, 2023 earnings are forecast to grow by 10.6%. Slowing growth means that P/E multiples for 2022 and 2023 aren't just historically high, they are even too high when adjusting for their growth rate.
These slowing earnings growth estimates coupled with higher interest rates are likely to lead to lower earnings multiples in future months. It seems to be a recipe that will be too hard for the market to fight off.
The ISM manufacturing prices paid index came in at 89.6 for April, which corresponds to a PPI index reading of around 5%. That would correspond to an interest rate on the 10-year in the range of 2.5%, which is nearly 90 bps higher than current levels.
The current 10-year rate is 3.85% lower than the two-year forward earnings yield on the S&P 500. Historically, that's a very low equity risk premium, especially since the 2008 recession, which ushered in this period of low rate policy. It isn't to say that the equity risk premium can't go lower, it just seems unlikely. Interestingly, before 2008, the region around 3.5% to 3.75% was the upper end of the historical range. It would seem to suggest the likelihood of it dropping from here is very slim.
A return to just the historical average of 5.25% over the past 10 years is nearly 1.4% higher than its current value, which would push the earnings yield on the S&P 500 up to 6.3%, giving the index an earnings multiple of 15.8, valuing the index at just 3,575, about 14% from its current value on May 6.
But really, even that may too high given how much time there is between now and the end of 2023. On May 15, 2016, the S&P 500 traded at roughly 13.7 times 2-forward earnings estimates while trading at 14.8 times in May 2017, around 14.3 in May 2018, and 14.2 in May 2019. The point being given how much time there is between now and the end of 2023, a multiple closer to 14.5 might be more appropriate for the index currently, and that would value the S&P 500 at 3,280, or 21% lower.
This may seem like an impossibility. It may be hard to grasp that the index can be overvalued by this large of an amount. However, history tells us it is, and while this period of easy money may support the multiple for a while longer, the Fed will be forced to tapper at some point, while Fed futures are now price in at least one rate hike by the end of 2022.
If earnings growth is being pulled forward, then valuations are too high and need to contract. Ultimately, it seems very likely that this scenario plays out at some point in the future.
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I am Michael Kramer, the founder of Mott Capital Management and creator of Reading The Markets, an SA Marketplace service. I focus on long-only macro themes and trends, look for long-term thematic growth investments, and use options data to find unusual activity.
I use my over 25 years of experience as a buy-side trader, analyst, and portfolio manager, to explain the twists and turns of the stock market and where it may be heading next. Additionally, I use data from top vendors to formulate my analysis, including sell-side analyst estimates and research, newsfeeds, in-depth options data, and gamma levels.
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