Many folks will tell you the stock market looks expensive.
And they’re not exactly wrong.
The S&P 500’s forward price-to-earnings (P/E) ratio – the index divided by the estimated next-12 months’ earnings – is historically high at about 21.2, according to FactSet. This is significantly above its 5-year average of 18.5 and 10-year average of 16.6.
With the S&P 500 (^GSPC) trading near its Dec. 30 all-time high of 4,808.93, the stock market will be under intense scrutiny by traders and investors who are seeking to justify these expensive valuations.
With that in mind, there are four big themes to watch in 2022.
Earnings: Will they continue to break records?
It’s been an extraordinary year as S&P 500 earnings are estimated to have surged about 45% year-over-year to a record $205.55 per share.
And the growth isn’t over, analysts say. According to forecasts compiled by FactSet, S&P 500 earnings are expected to increase by another 9.2% to $223.48 per share.
While it may look like 2021 set the bar high for earnings, keep in mind that there are a lot of major indicators pointing to pent-up demand – or growth that has yet to be realized – including the sky-high number of job openings, record capex orders, depressed inventory levels that have yet to be restocked, and $2 trillion worth of excess savings consumers are sitting on.
“The outlook hinges on whether the recovery in earnings, which has run well ahead of that in GDP, continues or even accelerates or whether it begins to slow back down toward trend levels,” Binky Chadha, at Deutsche Bank, wrote in a Dec. 10 research note.
Indeed, earnings are the most important driver of stock prices.
Profit margins: Are they sustainable?
Underlying many forecasts for earnings growth in 2022 is the assumption that corporate profit margins will continue to expand.
Here, the bar is set very high.
Perhaps the most surprising trend of 2021 was corporate America’s ability to deliver expanding profit margins amid inflationary pressures including rising raw material and labor costs.
Looking ahead, there are at least three reasons why profit margins could widen: 1) If the pent-up demand mentioned above drives revenue growth, margins could expand through operating leverage; 2) As supply chains ease and the Fed tightens monetary policy, inflationary cost pressures should ease; and 3) Companies have exhibited remarkable pricing power, and customers have yet to push back in a significant way.
“We are optimistic on margins,” Lori Calvasina, head of U.S. equity strategy at RBC Capital Markets, wrote in a Dec. 13 research note. “Supply chain and inflation problems persist. But some improvements are being seen, and most companies are managing through with strong pricing power that in some instances hasn’t been fully implemented.”
Interest rates: Will they actually rise?
Longer-term interest rates are expected to rise. The major Wall Street forecasters expect the 10-year Treasury note (^TNX) yield, which is currently hovering at around 1.5%, to gravitate toward 2% by the end of 2022.
This could present a challenge to the stock market as everyone ranging from billionaire investor Warren Buffett to Fed chair Jerome Powell have argued elevated valuations have been justified by low long-term interest rates.
One of the big reasons why higher interest rates are a negative for stocks is that it represents a higher cost of borrowing, which is bad news for the earnings of any company that has debt. And most big companies finance their operations with debt in some capacity.
Though, there’s a long history of forecasters predicting rising rates who were eventually proven wrong. Long-term interest rates have been trending lower for over 40 years and all along the way there’ve been countless numbers of financial market professionals who’ve incorrectly predicted rates would turn higher in a persistent way.
The chart below from Barclays (via interest rate strategist Steve Feiss) illustrates this. Each of the “hairs” represent the expected path of the 10-year yield at various points in time as predicted by professional forecasters. The blue line represents the actual path of the 10-year yield. That almost all the hairs point up and to the right means forecasters have incorrectly been calling for rising long-term rates even though those rates have actually trended lower.
Short-term interest rates, however, are almost certain to rise with the Federal Reserve signaling that it could raise its benchmark short-term interest rate three times in 2022.
That said, history says rate hikes from the Fed don’t spell doom for stock prices. According to analysis from Credit Suisse, stocks have historically rallied during months going into an initial Fed rate hike and continued to rally in the years that followed. See the chart below.
Valuations: Will they fall, and if so, will they bring stock prices down with them?
As I mentioned above, there’s a school of thought that argues rising long-term interest rates could cause P/E ratios to contract.
Regardless of what the cause is, contracting P/E ratios don’t necessarily mean stock prices have to fall.
In fact, the S&P 500 rallied in 2021 even as its forward P/E fell from about 23 at the beginning of the year to about 21 today. That’s because the earnings (E) grew at a faster rate than the price of the market (P).
The forward P/E has been falling as prices have been rising. (Source: FactSet)
It’s worth noting that valuations can be depressed or elevated for extended periods of time. In fact, some folks would argue valuations are not mean-reverting.
The bottom line
Ultimately, it comes down to earnings. Profit margins matter as they explain how sales translate into earnings. Interest rates matter as higher borrowing costs mean less earnings. Valuations matter in that they reflect the premium investors are paying for earnings.
That said, if there’s one big lesson investors learned during the coronavirus pandemic, it’s that corporate America is incredibly resilient and surprisingly adaptive. They will find a way to be profitable and increasingly so regardless of the challenges.
As BofA strategist Savita Subramanian recently said, “It’s dangerous to underestimate Corporate America.”
Sam Ro is the author of TKer.co. Follow him on Twitter at @SamRo.
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Source: finance.yahoo.com