Can U.S. Equity Markets Go Higher From Here?

Image by Yiorgos Ntrahas on Unsplash

“Are we at the top, or can we go higher?” is one of the biggest questions on investors’ minds right now. I will look at two things that can act as really large levers for or against the equity market, and that affect the basic strategies of our users at Tasseo (www.tasseo.io). The first is companies’ earnings. This helps answer the question: are current stock prices justified? The second I will look at are interest rates. This helps answer the question: where might prices be going? There are a lot of other factors that are affecting the market right now as well, such as covid, but the two aforementioned factors are two fundamental pillars of the current market cycle.

Do Company Earnings Justify Stock Prices?

A simple way to analyze this question is to first look at what the major market indices’ Price-to-Earnings (P/E) ratios look like over time. Let’s look at the largest, most traded index in the world first, the S&P 500.

Source: https://www.macrotrends.net/ ; www.tasseo.io

As we can see, the aggregate S&P 500 P/E ratio averages 17.4 since 1928, but recently it has drifted north of 20. It is currently at a local peak of 38. Earnings, however, are in the past. It may be that expected forward earnings are sufficiently high such that the expected P/E ratio is closer to the low 20s, but to think that 2022 earnings will be twice what they currently are now is a stretch. It means that much of the stock price growth is due to what is called “multiples expansion”. This is fancy lingo that just means that, for every dollar of earnings, a stock is valued at some multiple of that dollar (i.e. 17x, on average). Earnings haven’t doubled, but prices have, so this is what we call “multiple expansion.”

However, it’s not as if every stock has experienced this multiple expansion. Let us pinpoint which sectors of the economy this expansion came from, using sector ETFs as proxies of the sectors. Note, you can graph single stock p/e ratios at https://www.tasseo.io on the Design -> Charting pages.

Source: https://gurufocus.com

As we can see, the expansion hasn’t been in every sector (although there will be single stocks in each sector that have certainly outperformed their peers, this is just an average). Over the past five years, that expansion has stemmed largely from tech (XLK) and communications (XLC), which together are also the largest sectors of the S&P 500 index. Lesser contributions come in the form of real estate (XLRE) and energy (XLE).

Can anyone say “inflation”, i.e. housing and gas prices? The last sector with expansion seems to be consumer discretionary, which is interesting given the current pandemic, and stagnant wage growth of the retail buyer. Given we’re near a peak in prices with respect to pricing multiples, one has to have a lot of faith in the tech/comms industry to innovate and/or cut costs, or for housing and energy to continue their current rapid rise.

Covid has put a damper on the industrial industry recently, with the pandemic affecting international trade, construction, and development. Utilities and consumer staples are “defensive” sectors, so it is difficult to see how companies that provide very basic goods and services will all of a sudden seem incredibly attractive to investors. Healthcare might get a boost, but in my opinion, only specific sub sectors seem possible — those pertaining to biotechnology and vaccine development (which have indeed been on meteoric rises). One way to look at single stocks that have really exceeded the p/e ratio of their sector (often considered a short signal) and single stocks that are lower and may have value (often considered a buy signal) is at https://www.tasseo.io. You can go to the Design page, choose Condition Demo, and filter stocks by sector and p/e ratio.

That leaves financials, which have struggled relative to their peers. The government has curtailed the risk that they are allowed to take and has reduced their profitability through their monetary policy, which leads us to our next point.

How Could Interest Rates Affect the Current Market?

The U.S. Federal Reserve has had extraordinarily ‘easy’ monetary policy for a decade now. Let’s see how the S&P 500 has reacted to interest rates since 1990.

Source: Federal Reserve & www.tasseo.io

It seems as though every time interest rates declined, the equity market rallied. And, every time interest rates spiked higher, the S&P 500 had a negative reaction. One affects the other, so there is a feedback cycle involved, and for a variety of reasons.

If the economy is poor, the federal reserve will “loosen” monetary policy, buy bonds aggressively, and essentially flood the market with cash and lower interest rates. This makes borrowing easier, fostering growth, home-buying, purchases on credit, hiring, investment, etc. Markets tend to rise afterward. If the market overheats, the labor market gets tight (i.e. unemployment becomes very low), wages and prices tend to follow suit, causing inflation. Inflation causes people to demand higher returns for money they lend and other risks that they take, causing interest rates to rise. The Federal Reserve also raises its Fed Funds rate to raise base interest rates to slow the economy and bring down inflation. A little inflation is good, as economists say, it “greases the wheels” of business, but too much inflation (i.e. hyperinflation) and the wheels fly off the axis.

As the chart shows, we’re at the absolute low end of rates, virtually approaching zero, and the stock market is at its highs. This is due to the extreme low rate environment the Fed Reserve has perpetuated since the financial crisis of ’08. It’s lasted that much longer since its first attempt to increase rates was met with harsh investor sentiment and a surprising market collapse around late 2019 / early 2020, and the covid pandemic has forced the Fed to keep rates “accommodative”. Recent data has shown a surprising jump in inflation recently. According to MarketWatch, the prices have risen 4.4% in the past year using the Fed’s preferred PCE inflation gauge and an even higher 5.4% based on the better-known consumer price index.” Interest-rates near zero do not match this inflationary environment.

James Bullard (on the Fed’s Board of Governors), expects 2 interest rate hikes next year, citing data that showed wholesale prices rose 8.6% year over year in October, tied for highest ever in the 11 years the data has been tracked.

In my opinion, prices can certainly go higher from here assuming the new covid variants prove to be less dangerous than expected,  more people get vaccinated, technology firms continue to generate strong earnings or consumers find a way to keep borrowing to spend, or if the Fed does an about-face and halts its plans to begin tapering its quantitative monetary easing. A decade ago, post the financial recession, the pendulum swung heavily in favor of stocks rising after having fallen over 50%. It seems the data has slowly begun to go the other way.

The preceding post was written and/or published as a collaboration between Benzinga’s in-house sponsored content team and a financial partner of Benzinga. Although the piece is not and should not be construed as editorial content, the sponsored content team works to ensure that any and all information contained within is true and accurate to the best of their knowledge and research. The content was purely for informational purposes only and not intended to be investing advice.