It is amazing that, despite the tumultuous year, equity markets have been able to forge a meaningful path higher from a returns perspective, especially since the developed world is still wrestling with the COVID-19 pandemic. As of December 9, the S&P 500® is up 15.7%, with the Growth portion of the index up an impressive 29%. Believe it or not, the Russell 2000® is now up 15.4%, meaningfully closing the performance gap with large caps just in the last month or so of the year on the hopes of a full reopening of the economy.
From a pandemic, to global economic shutdowns, to record-breaking market volatility, perhaps we should simply be content with this year’s strong market performance as our Christmas present. Nevertheless, as has become our annual tradition, we challenge ourselves to determine what could be the single most important catalyst to drive markets higher in the new year and put that at the top of our wish list for Santa. Last year we asked Santa for clarity on trade policy and tariffs, and we got it, albeit a few weeks later than expected (January 15, 2020).
As we head into the holiday season, our annual Christmas wish list has gone through numerous revisions in just the last few weeks. COVID-19 vaccine? Got it. Renewed fiscal stimulus?? Confident we will get a new package(s) over the next few months. An allocation to Airbnb shares at the initial public offering (IPO) price (and before the eye-popping 100% one-day return on its debut)??? Sadly, Santa’s elves didn’t pass that particular request along…
So, as we slam the door on 2020 (and hopefully nail it shut), we find ourselves still pondering what should top our Christmas wish list. To that end, we have a simple, but urgent, request for our friends at the North Pole: positive earnings revisions (and a subsequent acceleration in earnings growth). Surely, not a “hard to buy for” kind of request!
Do They Know It’s Christmas?
There continues to be a big distinction between the recoveries experienced by Wall Street and the lack thereof by Main Street – while the markets and economy do tend to follow each other in and out of cycles, they don’t perfectly/precisely track each other. This year, in particular, we’ve seen a significant decoupling between the two, which we know most likely won’t last indefinitely. The key question is which one makes the adjustment to re-couple with the other? Does the economy make the necessary improvement to meet markets? Or, do markets hook down to meet the economy? As is with most things, the truth lies somewhere in the middle.
Despite the major indices sitting near all-time highs, there’s currently 83% of US GDP in states that have some form of economic restriction/lockdown in place as a result of COVID-19 – we’re unfortunately not out of the woods yet. As a result, we’ve had to tighten up our line of sight and focus on shorter-term, higher-frequency data points to get a sense of the near-term path forward to reopening the economy because the usual economic indicators like industrial production, monthly retail sales, and even GDP are simply too lagged/delayed to get a real-time sense of how the economy is responding.
- Through December 11, weekly airline passenger volumes fell to a three-week low and are still 25% below the passenger levels of February 2020.
- The public transportation app Moovit releases public transit data for major cities like Chicago, New York, and Philadelphia; all are registering activity that is still about 50% below pre-COVID levels.
- The growth rate for Johnson Redbook same-store sales (reported weekly for brick and mortar retailers) finally turned positive in October, but it is still growing at half pre-COVID levels.
- Restaurant bookings through OpenTable for online reservations in the United States are still down over 70% year over year. With varying levels of economic restrictions back in effect in Europe, OpenTable is reporting 97-98% year-over-year declines in Germany over the past month.
By these measures, the economic recovery is still quite sluggish and is losing some of its momentum heading into year end. That may have important implications for the trajectory of earnings growth and revisions in 2021.
The Gift that Keeps on Giving
When it comes to the price of stocks and their earnings, price may drive the market narrative in the short run, but earnings drive market prices in the long run. Thus, better-than-expected earnings growth should always be “the gift that keeps on giving” as it relates to equity markets, in our view, and is at the heart of our investment philosophy.
Although fourth-quarter earnings season has yet to start, the consensus earnings-per-share (EPS) growth estimates for all major equity indices in 2020 — with the exception of emerging markets — is handily sitting in negative territory (Table 1). The fourth quarter won’t be sufficiently strong enough to turn these figures positive as the projection for the S&P 500 is still -11% year-over-year … and slowing in tandem with the deceleration in the broader economy. Net-net a 13.7% earnings decline puts 2020 growth expectations on par with 2009-era growth, perhaps no surprise given we just lived through the steepest economic recession since the Great Depression. For 2021, earnings growth is projected to be nearly 22%. On a per-share basis, this translates into $169 for the S&P 500, which would be $6 above 2019 levels. At the end of 2021, if we are able to sustain these growth projections, we would expect the market to deliver a positive return for the year even with a modest pull-back in valuation. But, is that “enough” to support the market rally given the high expectations?
Strong, positive EPS growth across the globe is already the widely accepted expectation for 2021, but that is not what we are asking for from Santa.
Just like a child’s Christmas wish list asking for a doll or game with overly exact specifications, what we are asking for is not simply positive earnings growth (the equivalent of asking for a generic doll), but positive earnings revisions and a subsequent acceleration in earnings growth (aka, the L.O.L. Surprise O.M.G. Remix doll to be exact!). In other words, we look at how the consensus is adjusting estimates going forward. Not only do we wish for the growth rate to be positive, but we would also like to see upward revisions (that is, showing positive momentum). If so, we believe that is “enough” to fuel this market rally.
Time for the Egg Nog?
It may be known as the most wonderful time of the year, but it is 2020 after all. Therefore, before we go a-wassailing into the night, investors may want to refill their glass of egg nog as we note some points of caution for 2021 earnings. Looking at the S&P 500 by sector, the consensus EPS growth estimate for the Industrials sector, for example, is a whopping 79% in 2021 (Table 2, page 2). While that may suggest the consensus expectation is for a snapback in the “go outside” trade and a continuation of the pro-cyclical, value-oriented rally markets experienced in November, only one industry, airlines, is actually expecting a growth rate above the sector level. Let’s have a toast to consumers immediately jumping at the chance to get back on planes in 2021. Similarly, the Consumer Discretionary sector currently has an EPS estimate of nearly 60% and yet only the automobile and restaurant/travel industries are forecast to grow above that level. Let’s raise a glass to consumers immediately jumping at the chance to take that airplane trip and then stay at a hotel. We remain cautious on potentially overly optimistic expectations for pent-up demand in the typical “go outside” industries. For example, the US unemployment rate is at a still elevated 6.7%, and the savings rate is an eye-popping 13.6% compared to the pre-pandemic level of 8% in February. In other words, investors are really hoping for a snapback in these industries in 2021. Based on our assessment, the expectation for a snapback in EPS growth is actually being driven by just a handful of the still very challenged cyclical industries – we may have seen a sharp shift in investor sentiment in November, but the fundamentals for most of these cyclical sectors have yet to show any signs of turning the proverbial corner. On the other hand, the more defensive sectors, such as Health Care, Information Technology, and Consumer Staples (the “stay at home” trade), are all on pace to deliver positive EPS growth in 2020, and consensus expects a repeat performance in 2021.
Next-12-Months Price-to-Earnings Domestic Equity Valuations As of 11/30/20 (Chart 1)
Source: FactSet Research Inc., PNC
Next-12-Months Price-to-Earnings International Equity Valuations As of 11/30/20 (Chart 2)
Source: FactSet Research Inc., PNC
As Charts 1 and 2 show, equity valuations are fairly stretched across the globe. For example, all three large cap indices – S&P 500, MSCI World ex USA, and MSCI Emerging Markets – are at least 30% above their respective 10-year forward price-to-earning (P/E) averages. The Russell 2000 forward P/E? Try 40% above its own 10-year average. However, valuations are always a relative game and it is important to frame valuations relative to other asset classes, as well as the macroeconomic landscape. If equities seem expensive, consider investment grade (IG) bonds, where the yield-to-duration ratio for IG corporate bonds is at an all-time high and the Treasury yield to earnings yield on stocks is actually double its 10-year average, with both of these valuation metrics handily favoring stocks. This is what happens when interest rates are pinned at low levels and an unprecedented amount of monetary policy accommodation has flooded the financial system. Thus, we believe equity valuations are elevated, but are not sitting at extreme levels, especially when compared to other asset classes such as bonds.
Here’s where the egg nog comes in handy:
With most equity indices at or near their all-time highs and earnings multiples at these valuation levels, we continue to believe markets are priced for near-perfection when we know the reality is not picture perfect.
We are still concerned about a slow start to the year in the face of the lingering COVID-19 pandemic, uncertainties around the timing and magnitude of additional fiscal stimulus measures, the timeline of broader vaccine distribution/deployment, and the pace and timing of more fully reopening the global economy. As these uncertainties begin to subside, a much more optimistic view should come into focus for the second half of 2021.
What would give us cause for concern that valuation multiples would need to be re-set lower? It all comes back to earnings revisions. Despite a significant bounce off the second-quarter 2020 lows, the rate of change in earnings revisions is already starting to slow down and is right on the cusp of turning negative (Charts 3 and 4). If the S&P 500 was trading more in line with its 20-year forward P/E average of 16 times (x), then we would be a bit less concerned about the earnings backdrop heading into 2021. However, at a forward P/E of nearly 22x, accelerating earnings revisions matter so much more because this “expected” growth – especially in the “go outside” industries mentioned previously – has already been pulled forward into today’s prices. A failure to deliver on that growth would certainly call the sustainability of the market rally into question, in our view.
Domestic Equity: 2021 One-Year EPS Growth Estimates As of 12/9/20 (Chart 3)
Source: FactSet Research Inc., PNC
International Equity: 2021 One-Year EPS Growth Estimates As of 12/9/20 (Chart 4)
Source: FactSet Research Inc., PNC
If the pace and timing of vaccine production, distribution, and uptake are slower than expected and/or additional fiscal stimulus measures fall short of helping to successfully bridge the economic gap to a broader reopening of the global economy, this is likely to call into question current earnings expectations in 2021. With the acceleration in earnings growth tilted toward the second half of 2021, that does not leave the markets with much ability to make up for lost time if the reopening gets pushed back.
Will It Be a Happy New Year?
Assuming we do not have to institute additional draconian economic restrictions, the global economy should continue to recover in 2021 at a pace and level that should support robust year-over-year earnings growth. Much easier comparisons, particularly in the second quarter, should also be an added near-term tailwind. However, with valuations now well above pre-COVID levels across the equity asset class universe, this does suggest there is less room in 2021 for the equity markets to run based solely on multiple expansion – the bar is set higher for the year – and the baton must be handed off to earnings growth in order for the market to advance meaningfully from where it finishes 2020. Hence, our wish for the gift of positive revisions and a reacceleration in earnings growth.
Given the high volatility regime that has dominated much of 2020 and remains in place heading into 2021, we continue to position portfolios with elements that can provide ballast, while maintaining significant exposure to asset classes leveraged to a rejuvenated global market looking to slam the door shut on 2020.
For more details, stay tuned for our first-quarter 2021 Strategy Insights, What’s Behind Door #2021?, which provides our outlook for the new year.
TEXT VERSION OF CHARTS
Chart 1: Next-12-Months Price-to-Earnings Domestic Equity Valuations As of 11/30/20 (view image of chart 1)
|Date||Russell 2000||S&P 500||S&P Mid Cap 400|
Chart 2: Next-12-Months Price-to-Earnings International Equity Valuations As of 11/30/20 (view image of chart 2)
|Date||MSCI World ex USA Small Cap||MSCI World ex USA||MSCI EM (Emerging Markets)|
Chart 3: Domestic Equity: 2021 One-Year EPS Growth Estimates As of 12/9/20 (view image of chart 3)
|Date||S&P 500||S&P Mid Cap 400||Russell 2000|
Chart 4: International Equity: 2021 One-Year EPS Growth Estimates As of 12/9/20 (view image of chart 4)
|Date||MSCI World ex USA||MSCI EM (Emerging Markets)|