A U.S. earnings recession that was consensus thinking only a few months ago has evaporated out of view which, on the face of it, should be a tailwind for Wall Street into next year.
The flip side, however, is the degree to which that has already been priced into the powerful tech-driven rally since March – anyone entering the market now is buying at expensive levels.
And for those investors with a multiyear horizon, Wall Street’s growth potential and appeal relative to Treasury debt may dim considerably if borrowing costs don’t return to the historically low levels seen in recent years.
The second-quarter reporting season for S&P 500 companies getting under way is expected to show April-June earnings fell 6.4 per cent over the same period last year, according to I/B/E/S data from Refinitiv.
This would be the worst quarter in three years but not part of a technical recession – first-quarter growth was a slender 0.1 per cent and third-quarter estimates are around 1 per cent.
Remarkably, some analysts say the Q2 “whisper numbers” point to 1-per-cent or 2-per-cent growth. This would be the ninth time since 2002 that negative forecasts at the start of earnings season end up positive, according to Refinitiv’s Tajinder Dhillon. The time before that? The first quarter.
The 2024 outlook is even brighter – near-12-per-cent full-year earnings growth. Only energy and materials in Q1 and utilities in Q3 are forecast to register negative earnings growth among the market’s 11 sectors in any quarter next year, according to I/B/E/S data from Refinitiv.
It’s a rosy outlook, perhaps too rosy.
The S&P 500 index is trading at a 12-month forward price/earnings (P/E) ratio of 19.1, well above the 20-year average of 15.8, 30-year average of 16.5, and 40-year average around 16.
This is hugely inflated by the tech sector, which is trading around 27 times forward earnings. But it is still an optimistic forecast that will probably need an economic soft landing and no recession to come good.
“2024 earnings estimates have held up pretty well, we’re at high levels now,” notes Howard Silverblatt, senior analyst at S&P Global. “You are paying a nice premium here. Hopefully it’s worth it.”
The equity risk premium (ERP), a measure of the extra return investors can expect for holding stocks over risk-free Treasury bills, also indicates that stocks are not cheap.
It is a blunt tool, but a pretty good gauge of when stocks look under- or over-valued. The ERP is its lowest since 2004, suggesting equities may not be worth the risk right now.
If the era of low- and zero-interest rates is over, as many analysts argue the postpandemic world points to, investors should brace for a structurally lower ERP in the years ahead. Looked at another way, stocks could stay expensive for longer.
That’s the broad conclusion of a paper last year by Robeco’s head researcher David Blitz, who analyzed equity risk premia across a range of countries from data that goes back more than 120 years.
Total expected stock returns appear to be unrelated or perhaps even inversely related to the risk-free return, implying that the ERP “is much higher when the risk-free return is low than when it is high,” and vice versa.
If Treasury bill rates exceed 6 per cent, the ERP could even turn negative.
This challenges the “conventional wisdom” that stocks have an embedded risk premium regardless of the prevailing risk-free rate, Blitz noted. If he is right, higher interest rates and bill yields from here will squeeze the ERP even more.
A working paper from Fed economist Michael Smolyansky last month is equally gloomy on the long-term outlook for corporate earnings and stock returns, but for different reasons.
Mr. Smolyansky argues that falling interest and corporate tax rates accounted for over 40 per cent of real corporate profit growth from 1989 to 2019, and the decline in risk-free rates explains all of the rise in P/E multiples.
Assuming interest rates and Treasury yields don’t fall back to their post-2008 lows, it is difficult to envisage further expansion in P/E multiples. Markets appear not to be pricing in the “substantially lower” earnings growth that Mr. Smolyansky reckons will prevail in the future.
“With the expected slowdown in corporate profit growth and no offsetting expansion in P/E multiples, real longer-run stock returns in the future are likely to be no higher than about 2 per cent, the rate of GDP growth,” Mr. Smolyansky states.
“While this conclusion is certainly dramatic, it follows from minimal assumptions. The main assumptions are that interest and corporate tax rates cannot fall much further below 2019 levels. Everything else logically follows.”
Wall Street could get a shot in the arm from strong Q2 results and skirting an earnings recession, but the high may be short-lived.
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