The Big Picture

The S&P 500 hit a new record high, energized by the Fed's aggressive move to cut the target range for the fed funds rate by 50 basis points to 4.75-5.00%. There were cogent arguments that the Fed needed to be aggressive because the policy rate is still too high relative to the inflation rate.

The inference is that the Fed risks inviting tough economic times by keeping real rates too high for too long.

There were also arguments that suggested the Fed should not cut rates -- or certainly not by 50 basis points with the first move -- since the PCE inflation rate of 2.5% is still above the Fed's 2.0% target, weekly initial jobless claims are nowhere near recession levels, and stock prices are at record highs.

The inference is that the Fed could reignite inflation by easing policy too much, too soon.

We aren't here to litigate either case today. The market will do that on its own, but early returns suggest the market has literally bought into the argument that the Fed needs to be aggressive, and pro-active, to ensure the labor market doesn't weaken further and jeopardize the soft-landing outcome.

That buy-in has driven multiple expansion, which is to say stock prices have gone up at a faster pace than earnings estimates. That isn't an offside reaction with market rates falling and the Fed itself projecting another 150 basis points worth of easing between now and the end of 2025.

The key to it all, however, is that earnings estimates stay onside.

A Welcome Sight

So far, analysts continue to model generally good things for the earnings outlook.

The forward 12-month estimate is $266.63, up from $259.79 at the end of June, according to FactSet. Calendar-year 2025 earnings, meanwhile, are projected to be $276.84. That is 15.1% higher than the calendar-year 2024 estimate of $240.55. The calendar-year 2026 estimate sits at $311.38, up 12.5% from the current calendar-year 2025 estimate.

Double-digit earnings growth is always a welcome sight, but it is admittedly difficult to be "farsighted" into 2026 right now knowing the 2017 tax cuts expire at the end of 2025, leaving tax policy up in the air in front of the November election.

Corporate tax rates, individual tax rates, and capital gains tax rates are all subject to change based on the election outcome, and any changes will change the calculus for 2026 estimates.

For now, the 2026 estimate is a nice placeholder.

Multiple Expansion

The prevailing estimate in the market is the forward 12-month EPS estimate, which has been losing pace in recent weeks. Since the low on September 6, the S&P 500 has increased 5.6% while the forward 12-month EPS estimate has risen 1.5%.

It is encouraging to see the EPS estimate still rising, but the corresponding earnings multiple is as well. In the same period, the forward 12-month P/E ratio has gone from 20.4 to 21.5. The latter is a 34% premium to the 20-year average and a 19% premium to the 10-year average, according to FactSet.

As discussed in last week's column, that is a rich P/E multiple for the market-cap weighted S&P 500 but, to be fair, the price-to-earnings growth ratio of 1.43 (P/E divided by earnings growth rate) is a modest discount to the 10-year average of 1.49.

What It All Means

Earnings growth is a very important denominator, and why the earnings estimate trend will be a market driver. In turn, that is why economic growth is held dear by the market because earnings prospects ride on economic growth prospects.

Hence, the market has been cheered by the Fed taking an aggressive line with its rate cut, seeing it as a down payment on the house call that the economy will not suffer a hard landing.

Nobody wants that, because the harder the economy falls, the harder earnings estimates fall, and richly valued stocks follow suit. 

The market has made great strides on its charge to record territory, but companies need to earn their keep if the market is going to keep on keeping on at rich valuations that are easier to discount when earnings growth estimates are rising.

--Patrick J. O'Hare, Briefing.com

(Editor's Note: the next installment of The Big Picture will be published the week of September 30)