S&P earnings in 2022

The current consensus estimate of earnings for the S&P 500 index in 2022 is around $222. That would be a gain of 8% over 2021, which research organizations are now figuring will come in at around $205.

Typically, the estimates are on the bullish side, calling for a rise of 10%, +/- a little bit. Actuals typically come in a couple of percentage points below guesses made early in the year. This makes some sense, since the brokerage community is congenitally upbeat and, after all, caution/bad news doesn’t generate much revenue.

One notable exception is 2021. The consensus estimate from twelve months ago was unusually bearish. It called for a decline in 2021 of about 5% from the $174.50 in actual earnings the S&P achieved in 2020. At $205, the reality is going to turn out to be an unusually large increase of about 18% instead. To my mind, we don’t have to look any farther for a good explanation of why the S&P rose by 26.9% last year.

PEs and interest rates

As I’m maybe overly fond of saying, there’s no demand for stocks per se. There’s a demand for liquid investments, of which stocks, bonds and cash are the three principal types. We could toss in gold and crypto as well, but I think both flunk the liquidity test.

The table below compares Treasury yields with S&P 500 PEs. The PEs are based on historic earnings, not estimates for the following year. The 10-year yield is from the final trading day of the year.

yearend S&P 500 PE S&P earnings yield 10yr Treasury yield

2021 23 4.3% 1.52%

2020 27 3.7% 0.93%

2019 25 4.0% 1.88%

2018 20 5.0% 2.66%

2017 25 4.0% 2.46%

2016 24 4.2% 2.45%

2015 22 4.5% 2.24%

The earnings yield on stocks, 1/PE, is a rough and ready, academic finance-inspired, way of assessing the attractiveness of stocks with government bonds. If I buy a stock that’s trading at 25x earnings, then the share of company earnings that I, as an owner, have a claim to is 4% of the stock price. In a loose sense, this is comparable to the interest payment on a government bond.

There are big differences: “my” share of company earnings remains in the hands of management; there’s guarantee that these “payments” will continue at the current rate; there’s no terminal date when I get back the money I paid for the instrument; and the guarantor for the bargain I’ve struck is the company board, not the government.

I’m interested in these relationships mostly as a way of looking at what is likely to happen to the stock market PE as interest rates begin to rise this year. If the Fed raises the overnight money rate by 0.75% in three moves in 2022, and if we assume the entire yield curve shifts upward by the same amount (a significant “if”), then the 10-year Treasury will be yielding just under 2.3% by yearend. If the 2015-19 period is any guide–and it’s probably the best we have–then the yearend yield is compatible with a PE of 20+ for the S&P 500. Let’s pick 21. 10% earnings growth for 2022 and a flat market for the year would turn a 23 multiple on 2021 earnings into 20.9 on 2022 results.

This implies to me that while the market is working out the script for 2022 it will be hard for the S&P to rise by much, but it will be just as unlikely that the bottom falls out, either. If so, the better part of the action during the year will mostly likely be in individual stock selection rather than in identifying high beta and low beta sectors.

more tomorrow

upward pressure on rates = downward pressure on prices

As I’m writing this, the 10-year Treasury note yields 1.52%. This means that if I were to buy a freshly-issued one right now, I’d exchange my $1000 for twice-yearly payments of $7.51 each and the return of my $1000 ten years from today.

Suppose it’s tomorrow, Tuesday, and interest rates have risen overnight to the point where a brand-new 10-year Treasury yields 3%–meaning $1000 buys two payments of $15 each year plus the return of principal after ten. If I want to sell my one-day-old Treasury in tomorrow’s market, it will certainly be worth less than what I paid. I have almost no idea what the right figure is …$960? But my point is that rising rates push down the price of existing fixed-income instruments.

Because stocks are competitors/substitutes for bonds as liquid investments, rising rates push down the price of stocks as well.

Arguably, also, when money is more or less free, people are more cavalier in their attitude toward risk. When the returns on a money market fund or a bank deposit rise, and especially if they reach a point where those returns become significant (whatever that might mean), investors tend to pull in their horns a bit–creating a further contraction in stock values.

This suggests that as interest rates rise, the overall price earnings ratio for the stock market begins to contract, as well as that stock market investors begin to adopt a more conservative stock selection style.

the Fed intends to raise rates this year

We know this because the agency said it would last November, for one thing.

For another, interest rates have been at emergency lows, and negative in real (subtracting inflation) terms, for an extended period. After too much of this, and especially after the worst of the emergency is over, the economic system can begin a journey down the road of unravelling that ends in the country becoming another Brazil or Turkey. Not good.

Also, short-term interest rates are effectively at zero now, since the annual rate of interest the government pays for one-month loans is 0.06%. In theory, nominal rates could turn negative, as has happened in the EU. But I don’t think Washington has any appetite for this. My impression is that the weirdness of negative rates has offset any possible benefit. And real rates are strongly negative–meaning interest rate policy is highly stimulative–as things are now. In other words, as a practical matter there’s only one way rates can go, and that’s up.

when? how high? what’s the effect on earnings growth and PEs?

These are the important questions for the stock market.

more tomorrow

I’ve just updated my Keeping Score page for December, 4Q and full-year 2021.