Trefis

S&P 500 To Fall In The Next 12 Months?

By May 10, 2021 No Comments

Before the pandemic, S&P 500 companies clocked annual revenue growth of about 7% over 2017-19. The year 2020 was a brutal one for many, but average revenue growth for companies in the index wasn’t all that bad at -0.2%. Strong growth in revenues for technology firms cushioned the impact of steep declines for several sectors, including oil and gas, airlines, and consumer retail, among others.

Now, if revenue and profits are to grow by about 35% in aggregate over the next 3 years, then for the S&P 500 index to stay at exactly where it is, the Price-to-Sales (P/S) multiple, or by another measure, Price-to-Earnings (P/E) multiple, must shrink by 35%. In other words, the P/E must go from its current level of about 40 to somewhere around 26.

Is that possible? It sure is. In fact, that’s actually higher than where the P/E ratio for the S&P 500 has been during the 2017-2019 period – with average P/E ratio for S&P 500 at 23.7x in 2017, 21.6x in 2018, and 22.1x in 2019

But wait, what could be the trigger?

There must be an alternative for capital to fly away from the S&P 500. It might be the boring risk-free CDs and savings accounts. Or stocks that are cheaper and growing faster may represent a better bet.

Here’s one sequence of events we see unfolding. With more than $5 trillion in U.S. government stimulus money coming in the last year or so, with over $2 trillion recently and still more planned, there sure is a lot of capital out there. By summer, everyone who wants a vaccine will have received one. The economy has already started opening up, and as discretionary spending goes up, so will inflation. When inflation shoots up to 3% and potentially to greater than 4%, James Powell’s Fed will try to calm things down with words.

At some point, however, the Fed will be forced to act. No place to hide – the 200+ stories a day that the media will write about rising inflation and accompanying hardship to the bottom earners will become unbearable for the Fed officials. However, when the Fed starts raising rates, prices don’t just come down right away. Near-term rates will likely rise to 1.5-2% within 6-12 months from when the Fed starts raising rates from their current level of nearly 0%.

What does the Fed rate have to do with S&P 500’s P/E ratio?

When safer alternatives like savings accounts and CDs offer a higher return on the margin, investors will demand higher returns from other asset classes as well. Corporate and other bonds and fixed income instruments will need to offer a higher rate, creating a pull to higher levels for cash flow and earnings yield (E/P, calculated as earnings or cash flow to Price). This, in turn, will depress the P/E ratio, P/S ratio, or other similar multiples.

This can indeed bring the S&P 500 average P/E down from its 40+ levels to around 30 or even lower by late 2021 and the first half of 2022. Such a decline in the multiple would mean a 25% or greater drop in the S&P 500. Our interactive dashboard identifies trends in historical data to help you understand the S&P 500’s chances of a rise after a specific movement over the last few days or months.

Why the above set of events may not play out

It’s because of the money supply. Despite easy rate policies, there is still more U.S government stimulus being planned, while there isn’t evidence that the trillions in recent stimulus have been spent. If inflation shoots above 3-4% levels, the Fed starts increasing rates. However, if investors have excess cash or feel they didn’t quite capture enough upside in the market run-up of late 2020 and early 2021, they might use market drops as an opportunity to buy.

This scenario is quite possible and may imply that high market multiples and valuations are sustained for much longer – well into 2022 – until the money supply dries up further, and tighter Fed policies drive near-term rates to even higher levels. However, the longer this persists, the harder investors should expect the subsequent fall to be.

What can investors do?

We don’t think the Fed will necessarily be averse to some correction in the markets. As such, and however the events play out, investors would be wise to spread their bets. In fact, our high-quality portfolio – which has beaten the S&P 500 by over 3x – focuses on companies with strong long-term growth prospects: consistent revenue growth, high cash flow yields, and reasonably priced relative to their financials.  Also, our growth portfolio – which includes companies with demonstrated sales strength – has greater volatility/fluctuations but offers more stock upside.

We believe such high-quality and reasonably-priced stocks will be better able to weather such transient storms while providing strong long-term upside.