Since the beginning of the year the Dow, S&P 500 and the Nasdaq have increased by 15.8%, 20.1% and 17.4%, respectively. One of the biggest questions facing investors is will the Index values hold, can the markets continue to rise or will there be a pullback due to factors such as the Fed starting to decrease the $120 billion per month of assets it buys every month. No one can know for sure but here are four metrics to consider.
The S&P 500’s P/E multiple has slightly increased this year
Since the S&P 500 covers a broad spectrum of the stock market and there are more data points for it, we will focus on this Index to gauge what could occur going forward.
At the beginning of the year John Butters, Senior Earnings Analyst, at FactSet compiled these earnings expectations for the S&P 500.
- 2021: $167.82
- 2022: $196.10
With the S&P 500 at 3,756.07 on December 31, 2020 its P/E multiple based on these two years estimates were:
- 2021: 22.4x
- 2022: 19.2x
The S&P 500 earnings below are as of August 13, the date of Butters’ most recent weekly report. However, they should have only increased modestly the past two weeks since most companies had reported by then.
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- 2021: $200.81
- 2022: $218.60
With the S&P 500 at 4,509.40 last Friday this would make their P/E multiples:
- 2021: 22.5x (essentially the same as the beginning of the year)
- 2022: 20.6x (up slightly from 19.2x)
With earnings growth going to slow, the Fed probably starting to taper later this year and interest rates eventually rising, it will be challenging for P/E multiples to expand. Since this was a major driver of the markets rise there should be a dampening impact.
Earnings growth to slow
One metric investors use to judge valuations is how fast earnings are growing. This is typically helpful when the economic environment is in a fairly steady state but less so when the economy has experienced a shock, such as a pandemic.
- 2017: $133.61
- 2018: $161.56, up 20.9% (driven by tax cuts)
- 2019: $163.12, up 1.0%
- 2020: $104.40, down 13.9% (pandemic hit)
- 2021E: $200.81, up 43.0% (easy compares)
- 2022E: $218.60, up 8.9%
2021 saw a huge jump in the S&P 500’s earnings growth, but this was due to what could be called an easy compare to the downturn in 2020’s earnings.
It is therefore not surprising that the S&P 500’s earnings growth will slow dramatically in 2022 vs. 2021 since 2021’s growth is compared to 2020’s pandemic created downturn. While investors inherently know this will happen, it could dampen the multiples they are willing to pay for stocks.
Profit margins are at record highs
In Butters’ report he estimates that the net profit margin for the S&P 500 companies in the quarter at 13.0%. This is above the 5-year average of 10.6% and the previous record of 12.8%, which occurred in the March 2021 quarter.
He said, “If 13.0% is the actual net profit margin for the quarter, it will mark the highest net profit margin reported by the index since FactSet began tracking this metric in 2008.”
It is unlikely that companies will be able to maintain this level of profitability. Note that this chart is from Butters’ July 23 report where the June quarter’s profit margin was forecast to be 12.4%.
The 10-year outlook is for lower returns
John Higgins, Chief Markets Economist at Capital Economics, published a note that looked at Robert Shiller’s Cyclically Adjusted Price/Earnings ratio or CAPE against the average annual real return from the S&P 500 in the next ten years. Using data since 1945 it shows that the stock market should have a slightly negative annual return over the next 10 years. This is due to the CAPE ratio being around 39x vs. historically 14.5x.
However, when lower interest rates come into play it tilts the outcome enough so that there is a projected return of slightly more than 5% (the intersection of the black vertical line and the dotted line). If this occurs it would mean investors are looking at much lower returns over the long term than they have become accustomed to.