Despite Pullback, Earnings Revisions Support Rally
Given last week’s pullback, I remind investors to keep your eyes on the bigger target, the horizon six, 12, and 18 months away. Our work tells us that equity markets will be higher in the future. Additionally, from a positioning standpoint our proprietary sector single stock quantitative stock models still strongly suggest that offensive, like tech and cyclicals, areas will lead at the expense of cash and traditional defense sectors. I continue to recommend a barbell approach of Growth/FAANG and Value/Cyclicals.
The bears claim the rally since March 23 is non-sensical, a bubble, disconnected from the economy, and only rising because of Fed policy. The impressive equity market bounce that began after our preferred tactical indicators flashed a buy signal on 3/20 has not only made sense, but also has the underpinnings for more gains.
Our research is supported by the following: Extreme oversold condition that occurred on 3/20 and positive inflections in all our preferred tactical indicators; earnings revisions that have clearly turned less bad; investors valuing the S&P 500 and its constituents on some type of forward normalized earnings, NOT trough profits; and valuation expansion that is based on historical factor analysis of what drives multiples. Additionally, unprecedented monetary and fiscal policy has rained on the economy, with more likely. Finally, continued skepticism by investors, which is a contrarian positive, and helps equites climb the proverbial Wall of Worry.
Earnings revisions are clearly getting less bad. This is VERY important. This alone strongly backs the rally and makes a case against the market being illogical or only being fueled by Fed Policy. The historical precedent for this is powerful with no exceptions for major market bottoms since 1990. Markets don’t wait for profit growth to return to absolute positive before beginning to rally. The key driver has always been positive inflections and signs of less bad.
The number of companies with absolute revisions positive and improving has risen once again. I generally expect all these figures to continue to trend higher for the next 4-8 weeks. I will be on the lookout in coming months for more names are shifting from “earnings revisions still absolute negative but less bad” to “absolute revisions positive and improving,” or double plus.
Our research suggests that valuing the equity market or specific stocks on the current depressed profits levels from the self-inflicted corona virus lockdowns is misleading and not reflecting the true earnings power of Corporate America. Normalized earnings stream provides a better gauge. Investors should use at least 2021 and or 2022 EPS estimates, preliminarily a range of $180-200.
I take exception to comparing forward P/Es absolutely with historic readings. Without considering other factors, including interest rates, inflation one is really comparing apples and oranges. At the 2000 S&P 500 price and valuation peak, the fed funds rate was above 5.5% while today’s level is near zero. In our view, this alone clearly argues for a higher level of valuation for equities. I could make a case based on historical valuation analysis that P/Es should not only be at the north end of their long-term ranges but should also trade at all-time peak levels. If the current low level of interest rates stays in place and inflation remains quiescent, the forward P/E could reach 20-22x the normalized OEPS level for 2022, which may prove to be conservative.
Thus, we see a range of 3600 (20 x $180) to 4400 (22 x $200) as achievable over time.
