Contributed by William H. Sackley, Director, Master of Science in Finance Program; Professor of Finance; Cameron School of Business.
The overwhelming majority of news stories over the past 16 months has contained information deserving of such terms as ‘depressing,’ ‘tragic,’ or even ‘revolting.’ One exception has been news about the stock market. The S&P 500 has advanced 84% since its 2020 low, versus 80% for the DJIA and nearly 105% for the NASDAQ.
How could the country experience a near shutdown and still offer such a market advance? At first, market growth might have reflected a naïve expectation that the pandemic would not be as bad as it turned out to be. Later, market advances may have made sense based on Federal Reserve policies to provide liquidity, keep interest rates low, and tolerate any resulting inflation for a longer period of time. Looking forward, where might we suspect the market (S&P 500) to be one year from now?
Refinitiv, a global provider of financial market data, estimates earnings for the S&P 500 will grow by 35% in 2021 to $188. Of course, that growth has the benefit of being compared to reduced pandemic earnings. Refinitiv forecasts an additional 12% earnings growth for 2022. This would result in three-year (2020 through 2022) annualized earnings growth of 9%. This level of earnings growth is higher than the long-term S&P 500 EPS growth rate of approximately 7%, even amidst the worst economic downturn since the Great Depression.
More difficult than forecasting earnings will be forecasting a pricing multiple. At market bottom last year, the forward multiple was 13.1 times, but currently stands at 21.3 times. There is no disputing that the current multiple is high, surpassed only near the turn of the century during the past 37 years. Market participants want a better read on inflation to help predict Federal Reserve policy changes that will impact the pricing multiple.
The country has gone a relatively long time without experiencing much inflation. Somewhere between 3.5% to 4.0% annual inflation is often thought to be the trigger point for negative market reaction. Headline inflation was 5.0% YoY in May, versus 3.8% for core inflation. Using personal consumption expenditures – the Fed’s preferred inflation measure – the YoY change was 3.6% in April. Both the Fed and the White House claim current inflationary pressure to be mostly transitory.
Perhaps the strongest indicator of relatively benign inflation is the bond market itself. The current five-year breakeven inflation rate, or the spread between the yield on a 5-year Treasury bond and the yield on a 5-year Treasury Inflation-Protected Security, is 2.43% while that of the 10-year breakeven rate is 2.32%. This suggests bond investors expect the US inflation rate will average 2.43% over the next 5 years and 2.32% over the next ten. Certainly those rates have risen since their March 19, 2020 lows, but little happens in the stock market that did not occur first in the bond markets. Currently, bond investors seem to be accepting the view of (mostly) transitory inflation.
One year from now, the S&P 500 could trade in a range of 4,350 – 4,575, indicating a forward multiple of approximately 20 – 21 times. This is based on slower earnings growth for 2023 (7%), moderation of inflation, plus a Fed that is likely to move slowly by curtailing bond purchases and shaking off any “tantrum” before raising policy rates. Including dividends, this range suggests a one year return range of 4% – 9%. Investor euphoria? Not likely, but not bad considering our current lofty valuations.
A final comment on market sectors. There is little dispute that a small number of big names drove recent market returns. In fact, the five largest names by market cap now account for 20.7% of the S&P 500 market cap. Also, pricing multiples appear more reasonable when you ignore these market giants. Rotation into sectors that may benefit from whatever inflation we do incur may be a safer bet – such as energy, materials, or financials. As an example, how recently would it have seemed ludicrous to mention $100 and oil in the same sentence? With 60,951 contracts, the December 2022 WTI call option with $100 strike price currently has the largest open interest of all oil contracts. It is still time to take stock, but perhaps not the same ones as before.
Robert T. Burrus, Jr., Ph.D., is the dean of the Cameron School of Business at the University of North Carolina Wilmington, named in June 2015. Burrus joined the UNCW faculty in 1998. Prior to his current position, Burrus was interim dean, associate dean of undergraduate studies and the chair of the department of economics and finance. Burrus earned a Ph.D. and a master’s degree in economics from the University of Virginia and a bachelor’s degree in mathematical economics from Wake Forest University. The Cameron School of Business has approximately 90 full-time faculty members and 30 administrative and staff members. The AACSB-accredited business school currently enrolls approximately 2,600 undergraduate students in three degree programs and 750 graduate students in four degree programs. The school also houses the prestigious Cameron Executive Network, a group of more than 200 retired and practicing executives that provide one-on-one mentoring for Cameron students. To learn more about the Cameron School of Business, please visit http://csb.uncw.edu/. Questions and comments can be sent to [email protected].
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