There is a substantial and important change to February’s market multiples table (MMT) as the analyst community (both buy and sell side) appear to have embraced valuing the market via 2022 earnings vs. 2021 expected earnings, and the result is that support for stocks is now much closer to current levels, while ultimate upside targets are as high as 17% from current levels. Bottom line, this shift is bullish.
The shift also is highly irregular, which has me and others skeptical. Normally, analysts don’t start to value the S&P 500 via next year’s earnings until the summer (June-August). But because of COVID and the fact that this year will be part COVID hangover and back to economic “normal,” the markets are embracing 2022 earnings because it’ll be the first full “back to normal” year, and as such that’s the EPS figure that markets are trading off now.
Whether this is “right” is debatable, but in the end it doesn’t matter because it is what it is. Here’s what I mean. In this macro environment, there will be material buying support for this market anywhere below 19X 2022 expected S&P 500 earnings, unless the macro environment changes. So, while a 19X expected 2021 S&P 500 earnings is 15% below current levels, 19X 2022 S&P 500 earnings is just 7% below current levels, implying initial downside in this market has just been cut in half.
Practically, that does not mean this is a risk-less market. It does, however, mean that any pullback should likely be limited to 7%-10%ish (allowing for some over-shoot) unless one of the four pillars of the rally (Unending Fed support, forthcoming massive fiscal stimulus, vaccine optimism, no double-dip recession) is broken. And that’s a substantial improvement over any expected pullback/correction from last month’s outlook.
Regarding the rest of this month’s MMT, essentially, we had all positive outcomes, as the February “Current Situation” largely reflects the January “Gets Better If” scenario analysis, so it should be no surprise that markets have hit fresh all-time highs.
The flip side of that, however, is that markets continue to aggressively price in positive future resolution of basically all major macro influences, and that does leave this market vulnerable to real disappointment (and I don’t mean the GameStop volatility, I mean real macro disappointment that would cause that 7%-10% pullback). Point being, the trend is higher, but we remain focused on potential risks.
Current Situation: Widespread Improvement in January.
Literally all of the six macro indicators saw improvement in January and largely met my “Gets Better If” analysis from last month. Vaccine rollout improved and JNJ reported acceptable Phase III trial results for its single-dose vaccine. Economic data rebounded (largely) and there are really no signs the economic recovery is in danger of rolling over. Democrats utilized reconciliation to advance the stimulus bill and markets fully expect a minimum $1.5 trillion stimulus bill to pass in March. Treasury yields are near one-year highs, but so far the rise has been “orderly,” while the Federal Reserve emphatically dismissed any concern of negative consequences from its forward guidance (0% rates for years) or QE program, meaning there shouldn’t be any concern about tapering anytime soon.
Things Get Better If: We get more of the same.
Vaccine distribution continues to ramp up while COVID cases continue to decline (so no post Super Bowl party spike), economic data reflects the ongoing reopening of some states and continues to not signal any sort of impending slowdown, Democrats pass stimulus on the expected timeline, the rise in yields remains orderly (so not close to 1.40%-1.50%) and the Fed stays on message from January (no thought of tapering).
If that occurs, then markets get closer to a near “perfect” set up of 1) Massive stimulus, 2) Solid and recovering growth, 3) Looming end to COVID and 4) No spike in yields to suppress multiples. In that instance, a rally in the S&P 500 to the mid-4000s) should not be a surprise.
Things Get Worse If: Essentially any of the market’s aggressive expectations do not come true. Specifically, that means any of the following:
1) Moderate Democrats push back on more spending, and the size of stimulus drops or gets materially delayed,
2) JNJ’s vaccine doesn’t receive approval, one of the COVID variants proves resistant to the existing vaccines or the vaccine rollout gets further delayed,
3) The 10-year Treasury yield accelerates higher as markets price in the inflation impact of all the previous stimulus,
4) The Fed begins to discuss tapering of its QE program in the next two-to-three months and,
5) The economic recovery begins to stall after too long without stimulus.
If any of those events happen, I’d expect the S&P 500 to drop between 5% and 10%. If multiple events happen, I think then we are talking about a 15%-20% correction, because at that point we’d be endangering multiple pillars of the rally.
Bottom Line
The outlook for stocks continues to get more positive in the near term, plain and simple, and the stock positive formula of Massive (and unwavering) Fed support + Massive new fiscal stimulus + COVID declining and vaccine distribution ramping up is becoming more real, and stocks are rallying as a result.
However, this is not a market without risk, because a lot of these events have not only been assumed by stocks to come true in the future, but to be sustainable for the foreseeable future. That may indeed happen, but it leaves little room for error. As such, we remain vigilant to risks while admitting that for now, the macroeconomic environment for stocks remains decidedly positive.
Tactically speaking, this analysis again reinforces my preference for adding cyclical and value exposure: RSP for core holdings, financials, materials, industrials and hard asset ETFs.
For a complete list of ETFs and stocks, feel free to email me directly at kurt@ivoryhill.com.