• GVA Research

David Garrity on TD Ameritrade Network: What 3Q Earnings Mean For Markets Moving Forward

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1) S&P 500 Price Target of 5000 Indicates Modest Upside in 2022:

With the 3Q 2021 earnings season providing a roughly 10% outperformance versus expectations largely due to better-than-forecast profit margins, a surprise as the consensus was for inflationary pressures to instead compress margins, companies having pricing power should serve to encourage investors. While companies with earnings growth better than the S&P 500 have been outperforming the slower growers so far in 4Q 2021, we do note that even with the strong 3Q 2021 earnings season the 2022 earnings outlook was increased in just 4 of the 11 S&P 500 sectors while 2021 earnings estimates increased in 7 sectors as shown in the table below.

To our view, this offers a market set-up where corporate earnings will continue to outperform expectations. For now, the S&P 500 is forecast to earn $219.42/share in 2022, up +8.5% from 2021’s $202.20/share. Granted that an S&P 500 selling at 20.9x 2022 forecast is not a cheap market, but earnings growth without P/E multiple compression will lead to a price level of roughly 5000 on the S&P 500 (4986 to be exact). Given the above discussion, our view is that S&P 500 2022 earnings will be more likely $225/share, so 5000 as a price objective is not out of the question.

2) After Solid Rally Off March 2020 Lows, Prospects For 10-year Forward Returns Diminished, So Caution Warranted.

While the stock market may continue to rise over the course of 2022, we are concerned about the prospects for investment returns over the next 10 years. A valuation measure developed by Nobel Laureate Robert Shiller based on 10-year trailing earnings adjusted for inflation, the Cyclically Adjusted Price Earnings (CAPE) Ratio (the “Shilller PE”) now stands at the extended level of almost 40x as shown in the chart below.

While the Shiller PE ratio is ineffective in calling market tops, it does inversely correlate quite well with 10-year forward returns. Based on the November 2018 Brandes Institute paper titled “The CAPE Ratio and Future Returns: A Note on Market Timing”, the Shiller PE level of 40x is associated with modestly negative 10-year forward returns for the S&P 500 index as shown here:

A consideration that may serve to mitigate the prospect of negative forward 10-year returns is the role performed by disruptive technologies in accelerating economic growth through enhancing productivity and enabling entirely new economic activities, such as the Web 3.0 digital environment. Bear in mind the 2021 S&P 500 index composition with Tech at a 41% weighting is markedly different compared with that of 2000 when the Tech weighting was 28%. As a result, every sector other than Tech has a smaller weighting now versus 2000. Along with this, interest rates are substantially lower in 2021 (1.5% 10-year Treasury yield) versus 2000 (5-6% 10-year Treasury yield), something favoring equity valuation, especially high-duration stocks such as Tech. Bottom line, while we expect the stock market is likely to enjoy further gains through the end of 2022, we view the future with growing caution and would advise investors to be increasingly selective in their asset allocations.