Probably the most important thing any investor needs to know is that U.S. companies are very good at growing revenue and earnings.
You can see the truth of this on the chart. In the last 25 years, there have been three periods where S&P 500 revenue declined. There was the post-internet bubble (made worse by 9/11), the Great Financial Crisis, and the COVID-19 pandemic.
Each of these events was an outside shock to the American economic system that resulted in a spike in unemployment. (Even the small decline in revenue in 2015 was caused by Saudi Arabia’s attempt to destroy U.S. shale production by crushing oil prices.)
Absent a shock to the system, American companies can be counted on to grow revenue and earnings. It is as simple as that…
This is why individual stock prices and the S&P 500 index itself move higher over time. This is why buying stocks is always the right move. It’s also why constantly looking ahead to the next bear market is an exercise in futility (more on that in a minute).
I know the example of how corporations responded to inflation and record-setting Fed rate hikes in 2022-2023 has been repeated ad nauseam. But, that’s because it’s such a good example of just how good corporate America is at their jobs – and maybe how bad economists and strategist-types are at theirs…
It’s not a fair comparison. Economists live in offices, crunching numbers to make predictions. Corporations live in the marketplace and get their feedback from customers and suppliers…
It’s no wonder companies tend to be the more reliable indicators of economic health.
How We Got Here
The S&P 500 has set something like 70 new record highs so far this year. The reason for this is pretty simple: stock prices will grow so long as earnings continue to grow.
Earnings (and earnings estimates) for the S&P 500 are rising. At the start of 2024, the consensus was that earnings per share for the S&P 500 would be around $235.
The consensus has steadily risen all year and now stands at $250 in per-share earnings.
That may not sound like much of a change. But the fact is, earnings estimates tend to come down the closer we get to each quarterly earnings reporting season. The excellent people at FactSet research will tell you: that a year out, earnings estimates tend to be around 10% too high. Analysts steadily lower their estimates until companies report – and then ~70% of companies will beat those estimates.
Of course, it’s a game.
But, you can’t blame analysts for being conservative <wink wink, nudge nudge>.
And you can’t blame companies for corporate management for wanting to surprise their shareholders: “See? We didn’t even better than we thought we would.”
The fact that earnings estimates are rising is the biggest reason why stocks continue to rally, and why the S&P 500 keeps making new highs.
Ahead of first-quarter earnings, analysts were expecting the number for the S&P 500 to rise 1.2% from the first quarter of 2023. Actual earnings growth came in at 6.8%.
JP Morgan kicked off its first quarter 2024 earnings on April 12. The S&P 500 was already experiencing a mild correction. That correction ended on April 19. And it was blowout earnings that put a floor under stock prices.
Second quarter earnings start on Friday: July 12. Right now, analysts expect the companies of the S&P 500 to report 9.5% growth over last year. For the 3rd quarter, analysts expect 8.7% earnings growth and a whopping 14.7% year-over-year growth rate for the fourth quarter.
Will S&P 500 companies beat expectations when they start reporting next week? History would say yes, yes they will.
The Valuation “Problem”
The forward Price-to-Earnings (P/E) ratio for the S&P 500 is 21. For some perspective, the high forward P/E ratio for the index was set in August 1999 at 24. The most recent low came in October 2022 at 15.
So, you could look at the current 22 and think “Oh no! Stocks are overvalued!”
And plenty of investors do exactly that.
The problem with that kind of comparison is growth. Back in 1999, there wasn’t really that much earnings growth going on. Many of the “internet bubble” companies didn’t have earnings at all. The optimism was fueled by unquantified growth expectations, ie, “ohh one of the days we’re going to make so much money!”
That is pretty obviously not the case right now. Earnings growth – both realized and estimated – is a real thing. As an anecdotal example, Nvidia’s growth in real dollar terms has only been matched one other time in history – by Apple. That’s pretty good company to keep!
If the S&P 500 matches current estimates for earnings growth for calendar year 2025 of $270 a share, the forward P/E for next year is just over 20. If the companies of the S&P 500 do 3% better, and come in at say, $280 a share, the forward P/E falls to 19.5.
If they beat estimates by 6%, and report $290 a share, the P/E for next year falls below 19, in line with long-term averages.
My point here is not that these scenarios are destined to come true. The point is simply that the bull case is not out of control. Valuations are backed by earnings and growth.
The Next Bear Market
Earlier, I said: “…constantly looking ahead to the next bear market is an exercise in futility.”
I’d like to rephrase that, if I may. Looking at the bear market menu is fine. In fact, it’s a good idea to peruse the menu selections for what could trigger a fall in the stock market. And as it happens, today’s menu has some very appealing selections for the bears.
The chef has prepared the following delicacies for you:
- Rising unemployment
- Rising revolving credit delinquencies
- The Fed’s slow reaction to slowing data
- Government debt/interest payments
- Persistent inverted yield curve
I’m sure there are more, but those are the big ones. And the next time the market makes a ~10% correction – which it will – any or all of those will be served up as reasons for investors to panic.
Now, corrections and bear markets are different animals. Corrections are sell-offs that take place within bull market uptrends. The average correction takes the S&P 500 10% lower over the course of a month or two.
Bear markets are a prolonged change in trend. The average bear market takes the S&P 500 20%. And bear markets can grind investors down for 6 months or more.
Bear markets usually get served with a side of recession. Recessions are caused by a dramatic drop in consumer spending. And the only reason the American consumer pulls back on spending is in reaction to some kind of a shock to the economic system – a so-called Black Swan event.
In the 1970s, it was oil prices. In the 1980s, it was crazy inflation. In the early 1990s, it was the S&L Crisis. In the early 2000s, it was massive layoffs as the internet bubble popped, followed by 9/11. 2008-9 was the GFC. 2020, pandemic…
No way to say what will be the trigger next time. It’s always good to be on the lookout for the Black Swan.
Godspeed,
Briton Ryle
Chief Investment Strategist
Outsider Club
X/Twitter: https://twitter.com/BritonRyle
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