November was a historic month for stocks. The Dow Jones Industrial Average, S&P 500 and Nasdaq Composite rose 11.8%, 10.8% and 11.8%, respectively. Driven largely by multiple positive coronavirus vaccine announcements and partially by the Presidential election going to Joe Biden, it was the Dow’s strongest month since January 1987.
A few of the charts from a 102 page presentation and a weekly report by Goldman Sachs GS Chief U.S. Equity Strategist David Kolstin shows that the stock markets are at high valuations, but Kolstin still expects solid returns in the S&P 500 Index the next two years. He sees it hitting 4,300 next year and 4,600 in 2022, increases of 16% and 7%, respectively.
One of the key aspects for such a rally in the face of a third wave of Covid-19 leading to higher counts of cases, hospitalizations and deaths is the expectation that earnings next year will bounce back. While this will certainly occur to some degree, the big question is how robust will they be even with a vaccine. There will be some impediments such as how widely the vaccine is accepted (non-vaccinators and people being reluctant to take it so soon after being available) and will at least some industries incur additional expenses to run their businesses post-Covid-19.
S&P 500 earnings, price and valuations
Kolstin expects the S&P 500 companies to earn the following through 2024.
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- 2019 actual: $165 up 1%
- 2020 estimate: $136 down 17%
- 2021 estimate: $175 up 29%
- 2022 estimate: $195 up 12%
- 2023 estimate: $207 up 6%
- 2024 estimate: $218 up 5%
When you combine his S&P 500 price targets with these earnings estimates the Index’s PE multiple is projected to remain around 22x. This would be close to its recent high and not far from what it reached during the tech bubble. One major difference that does account for this is the current ultra-low interest rate environment.
To provide another perspective on valuations is to look at the highest and lowest valuation metrics. What pops out is that the quintile (20%) of the highest valued portions of the S&P 500 are trading at a 35x PE multiple, higher than during the tech bubble.
Hurdles include recovering profits, margins and sentiment
The most obvious hurdle for stocks to continue their hot streak is the high valuation levels they are trading. However, there are also some short-term and mid-term speed bumps besides just valuation.
Kolstin is projecting S&P earnings to hit $175 vs. the current consensus of $169. While this wouldn’t take a lot to have the consensus move higher, it typically fades as the year goes by. Additionally, to get to even the consensus number revenues and margins will have to recover to pre-coronavirus levels and then exceed them.
Net profit margins peaked at 12.0% in the September 2018 quarter and fell to 11.5% in the September 2019 quarter, almost six months before Covid-19 hit the U.S. Additionally they decreased year over year in every quarter from 2018 to 2019. It doesn’t seem likely that given the economic environment the U.S. and globe is experiencing that margins should rebound all the way back to 2019 levels.
Kolstin also has a sentiment indicator for stocks. It measures stock positioning across retail, institutional, and foreign investors versus the past 12 months. He writes, “Readings below -1.0 or above +1.0 indicate extreme positions that are significant in predicting future returns.” As you can see stocks are in a very stretched position.
Peel the onion for a bit of positive info
John Butters, FactSet Senior Earnings Analyst, calculates that the portion of the S&P 500 without the oil, airlines and hotel industries would have posted a 4.3% increase in earnings vs. the 6.3% total decline in the September quarter. This does show that the segments of the economy that are not being decimated by Covid-19 are doing pretty well given the challenges and increased costs from the virus.
Another interesting chart in Kolstin’s package is short interest in stocks. Part of the read from this is that investors who go short are not taking large bets about the markets declining. The other aspect to keep in mind is that shorts’ buying back shares to close their position is a positive for stocks. When there isn’t much being shorted, there isn’t that much to be bought back.