As of last Friday, the Standard & Poors Index, the basis for index funds under the same banner, had recorded a year-to-date appreciation of 11.29 percent. While this is a commendable number, it was attained entirely (and then some) on Price/Earnings multiple expansion. A year ago, the index had an average P/E ratio of 20.34. It is now 44.41. In a nutshell, stock prices went up while earnings went south. Covid played a huge part in this earnings decline, and the vaccination is expected to play an equally huge role in causing earnings to return.
This begs the question: what are earnings expected to be going forward post-Covid? According to published pronouncements from Standards & Poors, earnings for 2021 are expected to be $178.08 for the 500 stock index. If this forecast is accurate, it would imply a P/E ratio based on 2021 estimated earnings of 23.22. In 2022, assuming we can see out that far, earnings are predicted to rise to $202.75, which puts the P/E ratio at that point (assuming no change in the overall value of the 500-stock index) at 20.39. Historically the P/E ratio has been about 16, although it has been subject to a great deal of fluctuation.
As the name implies, the Standard & Poors 500 is a composite of 500 stocks of the largest firms in the country. The stocks are weighted by market capitalization, so a large firm like Amazon has more impact on the index than a smaller firm. Six firms make up 22.13 percent of the weight of the index: Apple, Amazon, Facebook, Netflix, Alphabet (parent of Google), and Microsoft.
The Standard & Poors also maintains an index of the next 400 firms in terms of size. This index, called the Midcap 400, is up 19.04 percent year to date. A third index of the smallest 600 stocks is up 20.66 percent in this same time frame. Both these indexes are doing almost twice as well as the largest index. What does this imply?
First, the S&P 500 index is having some issues relative to the larger market. It included the most favored stocks for so long that their valuations may now be called into question. Last week, Netflix disappointed in terms of subscriber growth, and this led to the stock correcting over ten percent. If companies like Netflix, Amazon, and the like were the chief beneficiaries of the lockdown associated with the pandemic, does it not follow they would be hurt relatively speaking when the economy recovered?
In a similar vein, could it be that smaller firms, who bore the brunt of the lockdown, are now ready to take back the business lost to the larger firms? Time will tell as to how much consumers’ shopping habits have been altered by the pandemic. Initial reports are that consumers just want to get out and take their lives back. That could take the form of more socializing and less binge-watching television. It could also take the form of travel, at least within the US this year. Restaurants are scrambling to find staff, which may mean higher prices and slower service. In fact, with a high savings rate, it would seem that higher rates of inflation will be a foregone conclusion.
A second advantage the mid-cap and small-cap indexes have over the flagship S&P 500 is a more reasonable valuation. A third advantage is that smaller companies are more likely to already be paying corporate taxes, as smaller firms lack the know-how to avoid paying taxes in the manner of larger enterprises. This means that smaller firms will not feel the impact of the proposed minimum corporate tax rate as much as larger firms, should it be enacted. While the rate at this point is largely undefined, it will be a jolt to the profits of large companies like Amazon, who have never paid taxes due to their heavy investment spending. Companies who play games with keeping their profits abroad to avoid US taxation will also be targeted.
Putting all of this together, we may yet have a correction, or we may already have had one. The term to describe leaders falling back and being replaced by other firms is “sector rotation”. A historical example is 1974-82: in this time frame, the Standard & Poors index essentially went nowhere, while the smaller capitalization index tripled. We may be witnessing the same now, as the environment for large companies becomes increasingly hostile. Pressure on large-cap names comes from not just valuations and taxes but also from antitrust, foreign governments’ desire to tax earnings at a higher rate, political and social issues, and privacy concerns.
In 2017, the S&P 500 went up 19.4 percent. The chief reason earnings went up that year was the decline in corporate taxes from 35 percent maximum to 21 percent. While we are entering a very strong and recovering economy, should the tax increase be enacted into law, it will impact valuations to the downside. The chief questions are whether the increases will be enacted and when, as well as in what form.
The Economy
With pent-up demand and a high savings rate, it would seem logical to assume the economy will do well as the lockdown becomes history. Estimates are all over the map, but all are positive.
The chief concern at this point is the adequacy of labor relative to demand. Demographically the country has more people dying than being born, even before Covid put its thumb on the scales. Without some sort of controlled immigration, there is no easy way to fix this.
European countries have addressed this with worker visas of three to five years. If there is no work, the foreign workers are sent home. Critics say the process is easy to circumvent. In Europe, stiff fines and jail time await an employer who tries to hire a worker with an expired visa or below the legal wage. In the US, the onus has been on the employee rather than the employer.
Inflation
It looks like America’s efforts to avoid inflation are about to run out of string. The record prices for housing are pressing the inflation rate, as is the shortage of semiconductor chips to build everything from appliances to automobiles. It is predicted that there will be fewer sales when supply is constrained.
Right now, there are about thirty container ships outside the port of Los Angles and Long Beach waiting to unload. It is estimated that they hold collectively 45,000 containers of goods for everything from clothes to washing machine parts. Until the logjam is resolved, look for bare spaces on store shelves as a result.
Interest Rates
Efforts by the Federal Reserve to hold down interest rates may also be running out of options. The Fed continues to champion full employment. However, the combination of jobs being in areas where people cannot or will not commute or move to coupled with a denial by employers as to what is required in terms of compensation to hire, is leading to an impasse in stronger job growth. If wages rise faster than interest rates, the effect will be to cause people to acquire things that they think will appreciate in value faster than inflation overall. Should this mindset take hold, the Fed’s job will be greatly
complicated.
The Stock Market
Floating on the liquidity furnished by the Federal Reserve, stocks continue to rise on the backs of higher earnings, low-interest rates, and high demand. Reports of higher taxes under consideration are spooking the market, although nothing has been proposed or voted on. Given the reaction to what has been proposed thus far, the passing of tax legislation may provide a buying opportunity for those that do not hold some of the highflyers which have more compelling valuations.
Addition to the Firm
Barnett & Company welcomes the addition of Katie Stuart to our staff. Katie comes to us from the banking industry, where she excelled at customer service. Katie is a native of Newport, Tennessee, and an MBA graduate of Carson-Newman University. Katie will be assisting Yvonne Hobbs with client needs as well as serving as the office manager. She has embarked on the CFP program and will be the resident expert on financial and retirement planning. We at Barnett & Company welcome her aboard.
Warren M. Barnett, CFA
April 27, 2021