The Big Picture
Can we just stop for a minute and marvel at how extraordinary the stock market's performance has been since the lows last October?
Not that the rebound off the low seen in October 2002 wasn't remarkable, or the rebound off the low seen in March 2009 wasn't remarkable, but there is something about the move that has been made in the last three-and-a-half months that is truly extraordinary.
Since its low on October 27, the S&P 500 has surged 22.6%! The Nasdaq, which saw an earlier low on October 26, is up 26.5%!
It sure does look good on a chart, as one might expect knowing the market has gone up in 14 of the last 15 weeks.
There have been multiple precipitants for this market move:
- The Treasury Department's calming quarterly refunding plan announced in October
- Indefatigable buying of the mega-cap stocks
- Lower interest rates
- Improving inflation trends
- Expectations that the Fed is done raising rates and will shift this year to cutting rates
- Assumptions that the U.S. economy will avoid a recession
- Short-covering activity
- Performance chasing/momentum buying
- Increasing equity allocations from underweight (or sidelined) positions
- Rising earnings estimates
We might have missed some, but we trust that our readers get the point. There has been a lot driving this rally effort. The weakest driver of them all, though, is the one that matters most: earnings estimates.
Not Measuring Up
The earnings situation is much improved, but that's very much a relative barometer.
S&P 500 earnings declined three straight quarters from the fourth quarter of 2022 through the second quarter of 2023. The third quarter of 2023 featured 5.3% year-over-year growth, according to FactSet; meanwhile, the fourth quarter blended growth rate sits at 3.1%.
For good measure, first quarter 2024 earnings are projected to be up 3.7% and calendar 2024 earnings are projected to rise 10.9%.
We noted in last week's column that the S&P 500 was trading at 20.4x forward twelve-month earnings, which was 16% premium to its 10-year average. Today it still trades at 20.4x forward 12-month earnings -- but this is where the earnings estimate picture fails to measure up relative to the stock market's performance.
As noted above, the S&P 500 has surged 22.6% since its October 27 low. The market, to be fair, has followed the trend in earnings estimates (higher), but to be frank, it has overshot that trend by a mile.
In the same period the S&P 500 has gone up 22.6%, the forward 12-month EPS estimate has gone up just 2.7% to $246.17, according to FactSet.
What It All Means
The gap between the price of the S&P 500 and the forward earnings estimate is the footprint of multiple expansion. That's a fancy way of saying stock prices are going up faster than earnings estimates.
Multiple expansion isn't necessarily a bad thing. You see it in bull markets as performance chasing kicks in, or the fear of missing out on further gains compels added buying interest. Naturally, what you also hear amid multiple expansion is a lot of rationalization of the move:
- "The company is going to grow into its valuation."
- "Analysts aren't fully understanding the company's growth prospects."
- "The stock can sport a premium valuation today, because interest rates will be lower in the future."
- "Yeah, the stock is overvalued based on 2024 estimates, but if you look at it based on 2026 earnings estimates, then it isn't overvalued."
It all sounds reasonable in the moment -- until the moment arrives that squashes those growth expectations. It is then that the overvaluation becomes crystal clear in a material decline in the stock price. More than a few companies this earnings reporting season have had this comeuppance. Tesla (TSLA) and Snap (SNAP) are a few that come to mind.
In any case, we are not here to throw stones at any individual company. Our aim is only to highlight for index investors that valuation is a constraint for further price appreciation if forward earnings estimates don't start picking up.
Could the market move higher if the forward earnings estimate remains static or even falls? Sure, it could if the most heavily-weighted stocks keep moving higher or animal spirits keep speculative interest alive.
Just bear in mind that the further the market, or an individual stock, rises without a concurrent pickup in earnings estimates, the harder the fall could prove to be if prevailing earnings expectations are not met.
Ideally, the gap between earnings estimates and the S&P 500 price level will narrow because earnings estimates see a stronger pace of upward revision. The way things stand now is extraordinary in terms of the price level and remarkable in terms of the valuation.
It is indicative of a bull market, but it is also indicative of a market that has little room for challenges to the growth outlook that would diminish earnings prospects.
