The Full Story:
If you want to know the future value of a chosen market index, you need only to properly forecast two variables. First, you must properly forecast future earnings (E). Second, you must properly forecast future valuations (P/E). For instance, if you expect $100 in future earnings and a 20x valuation, you will forecast your index value at 2,000.
Each day, the news clips that snow-blind analysts make their way into adjustments in earnings expectations and valuations expectations. Let’s first level set with each of these variables and then make determinations on direction to inform our own year-end forecast.
E is for Earnings
Q3 earnings season kicks off next week, ominously, on Friday the 13th. For the past three quarters, earnings have declined compared with year ago levels, a rare occurrence outside of recession as seen below:
For the upcoming quarter, analysts expect another, albeit slight, earnings decline. Based upon upside surprises over the past few quarters, we expect the final tally for this quarter will result in positive earnings growth. If that’s the case, this will be the first positive report in a year!
For the fourth quarter, analysts currently forecast an 8% earnings growth rate. For 2024, analysts forecast a 12% growth rate. Many doubt these figures for a myriad of reasons, but if you squint at the visual above, earnings transitions from negative to positive tend to unlock outsized upside.
The Dow rallied 300 points on Friday. The September labor report detailed 366,000 payrolls added last month versus the 170,000 anticipated. Continued labor market strength translates into continued consumer spending strength which translates into continued economic strength and therefore, earnings strength. This report only increased the odds of a positive third quarter earnings season.
P/E is for Valuations
Currently, the S&P 500 trades for approximately 18x estimated earnings. If we compare this level with long-run averages, the current valuation appears stretched:
Clearly, however, valuations vacillate. The runup in valuations from 1980 to 2000 (8 to 25) provided an enormous tailwind for S&P 500 investors. Likewise, the fall in valuations from 2000 to 2010 (25 to 12) provided an enormous headwind for investors. Investors gained 18% annually through the 1980’s and 18% annually through the 1990’s. In the 2000’s investor returns dropped to -1% annually.
Clearly, valuation trends matter (it’s math). Currently, the S&P 500 valuation trend better resembles the sideways chop of the 1960’s. Over the decade of the 1960’s, the S&P provided investors with returns of 8%, reliant on earnings growth and dividend yields for lift, as seen below:
Larger directional trends in valuation stem from larger directional trends in interest rates. As bond yields fall, equity valuations rise to maintain equilibrium between the two asset classes, and vice versa. Note that in the chart above, the trend upward in rates through the 60’s and 70’s corresponded with lower total returns for stock investors, while the trend downward in rates through the 80’s and 90’s corresponded with higher returns.
Interest rate calculations include forecasts for inflation, creditworthiness, Central Bank policy and marketplace liquidity. In other words, it’s complicated. However, in our current environment, any reports of disinflation or Federal Reserve policy downshifts places downforce on interest rates and therefore upforce on valuations.
The September labor report showed a continued glidepath lower for wages, with average hourly earnings rising 4.1% over the past year—only 3.4% when using a 3-month rolling average. The Fed wants wage growth of around 3%, bringing the target within range.
Continued wage disinflation supports continued disinflation overall, reducing pressure on the Fed to do more, and reducing pressure on long-term interest rates. As such, this report added upward pressure on P/E and improved the odds that valuations need not fall further into year-end.
Paging Mr. Claus
Taken together, with earnings gaining positive momentum starting October 13th and interest rates potentially stalling out at these levels (dependent upon the upcoming CPI inflation report on October 12), markets now appear anxious to rally into year-end.
The one pre-condition we set for the start was a sentiment decline down to 25% bulls. We didn’t get there. We got down to 27.8% at the end of last week. However, when the market fell 270 points early Friday morning, I heard a bearish strategist on CNBC declare, “Everyone is afraid of everything right now!” and felt that our sentiment correction call seemed well-enough fulfilled. We must clear the CPI report first, but should that arrive benign, it’s time to cue the Claus.
Have a great weekend!
David S. Waddell
CEO, Chief Investment Strategist
