First, expectations for Q1 at the start of the year were for growth of 16% y/y, so there has been strong upside over the past few months. Also, the level of earnings on a seasonally-adjusted basis is now 16% above pre-COVID levels. All this to say that it has been an extremely strong quarter for earnings results, even though you might not have heard much about it.
So, where does that leave equities? For one, it helps justify the run we’ve seen over the past six months or so, keeping in mind that the market is always moving ahead of the news. From a valuation perspective, it’s hard not to conclude that stocks overall are pretty richly priced, so the run in earnings helps a lot. Here are some examples.
The forward price-to-earnings multiple on the S&P 500 is elevated, now sitting at about 22x consensus forward-year earnings. That is up from about 18x pre-COVID, but it’s little changed over the past eight months. In other words, there was a sharp re-pricing through the early stages of the pandemic, but now it looks like underlying earnings are carrying a lot of the load again. Does that repricing just reflect the drop in long-term interest rates? See next point…
The spread between the S&P 500 forward earnings yield and 10-year Treasury yields has tightened considerably, but is not pushing beyond past-decade readings yet. That said, at just above 3 ppts, it is at risk of compressing through the lows set in early-2018. Recall that was the richest level of equity valuations versus Treasuries of the post-financial crisis cycle, and the S&P 500 subsequently went sideways for more than two years. So, it looks like valuations today have run somewhat ahead of interest rate fundamentals alone, but not unlike what we’ve seen in recent memory. Perhaps that’s one reason why stocks initially reacted positively to a much weaker-than-expected payrolls report (and drop in Treasury yields) on Friday.
Bottom Line: Stocks look pretty fully priced versus interest rates and earnings, but not beyond the realm of what we’re used to seeing. The best case scenario is that interest rates remain mostly in check and earnings momentum continues through the reopening. A much worse scenario would be if constraints on supply (both goods and labour) temper growth but push inflation and interest rates higher. The truth might lie somewhere in between, which could be digested by a more rangebound market.