As many expected, earnings are coming in hot. Analysts and companies vastly underestimated the speed of this recovery which is leading to forward estimates being ramped up higher every day. We’ll have more data in the coming days, but it looks like we will have the largest number of companies beating their original guidance and a record on the actual size of those beats.
Simply put, no one knew how to model a pandemic induced shutdown or how fast we would come back to normal. Previous recessions and recoveries don’t give much assistance for those sticking to historical tendencies in forecasting today. It is remarkable how well our economy is recovering and we’re not even back to full employment yet. Throw in trillions of stimulus from the U.S. and other nations and one could argue we’re years away from peak earnings as well. Stock markets don’t top until after earnings do.
Sadly, there are plenty of pockets still suffering economically. Hospitality, travel, restaurants and commercial offices to name a few. However, they are being outpaced by larger sectors of the economy such as housing, technology, autos and the Internet of Things. As we move along towards 2022, S&P earnings could be closer to a $210 run rate from prior expectations of sub $180. Applying a 20 P/E points towards the S&P at 4,200. Companies will have to keep guiding higher in order for us to accelerate on the upside from yesterday’s closing level of 4,134.
We have been laying out the bull case for weeks now and it looks like a lot of this news is priced in. What could go wrong from here? Let me count the ways (and rebut why we shouldn’t be too concerned).
1. Increasing taxes: Biden’s expected proposal to raise taxes on the wealthy, including doubling the long-term capital gains tax rate to 40%, caused a quick drop in stock markets yesterday afternoon. Any proposal here will be met with defiance from moderate Democrats, almost all Republicans, and many who are up for re-election next year. Raising taxes isn’t easy. Whatever does get done, if at all, will be lower than proposed and not a big drag on corporate earnings. Increasing corporate taxes would be more damaging to stocks than raising personal taxes. Companies repatriated cash, paid out bonuses, increased wages and made plans for increasing domestic capex when taxes were lowered a few years ago. Reversing this makes little sense coming out of a recession and could cause a minor sell-off for stocks.
2. Inflation: Some are concerned with excessive money printing leading to a highly inflationary environment. Today, Covid shutdowns of factories are wreaking havoc on supply chains. Prices are definitely rising. Asset prices are all elevated, housing included. But what happens in 12-18 months when Covid vaccines are globally available and factories shift back to full time? Supply chains will get back to normal. When stimulus checks end and the government hopefully slows the printing presses, our sugar high will subside. Today, it looks like inflation is only a one to two year problem. That doesn’t mean we can’t prepare for inflation, but we shouldn’t expect it to last.
3. Valuations: It is true we are near all-time highs from a P/E standpoint when taking out the Nasdaq bubble of the late 90’s. This is typical when coming out of a recession, prior to a rebound in earnings. As mentioned, we’re going to get back to and exceed 2019 EPS quicker than anyone thought. Stocks are growing into their P/E’s. As always, low interest rates means P/E’s will remain higher than historical measures. Money has to find a home and very few retail investors want to own fixed income that offers a negative real rate of return. Valuations are high, but there are plenty of reasons to believe this can stick around for a while.
4. Good news priced in: Markets are a discounting vehicle and have priced in great news. We’ll need to keep seeing sizable beats in order to extend the positive news flow. Maybe it is time for choppy, range-bound action until there are clear signs that 2022 GDP will again be above our old trend line of 2% – 3%.
5. Covid vaccines slow roll out / new variants: Here is a big wild card. The longer we go without reaching herd immunity, the likelier we get more variants. Africa alone only has a quarter of their population not wanting to take any vaccine. Vaccine rollouts in Israel and the U.S. have been great, but globally we’re back to setting new highs in new positive Covid cases. Numbers are not improving by any stretch. A new, stronger variant that subverts current vaccines would crush all of our hard work over the past year.
6. Deficits: The 2021 U.S. deficit is estimated to be 15.6% of GDP, making it the largest shortfall since World War II. Total debt has outpaced our economy and is expected to be 108% of GDP as well, joining a rather unpopular list that includes Japan, Italy and Greece. Needless to say, they have not been good role models over the past few decades for investors. Granted, most developed nations’ finances are a mess today, but we have to rein in spending at some point. Laws of diminishing returns are already here. In the 70’s, every additional dollar of government issued debt circulated around the economy and produced $4 of GDP. Today, that same dollar only increases GDP by 70 cents. Economies can’t finance their way to prosperity forever. We’re reaching a tipping point.
7. Wage Pressure: Shortages for skilled labor can be found in housing, restaurants, Uber drivers, police, engineering and manufacturing. A McDonald’s# franchise in Florida is paying $50 for job applicants just to come in for an interview. There is a real shortage of specialty skilled labor in all the places we need them. Reeducation programs should be expanding. Many Americans are making just as much money from government handouts as they would going to work, so why not wait it out until the free money dries up? These imbalances ebb and flow over time, though wage pressure is a wild card worth our attention. Most recessions are preceded by rapidly rising wages.
Any one of the above worries could lead to a near-term correction in the market. A straight line advance from last March can’t keep going uninterrupted. A hint of Biden’s tax plan that would raise capital gains taxes caused a quick 1% drop in a few minutes. Investors in NY and California could pay 60% of their gains back to the taxman when incorporating State rates. Again, this is unlikely to pass in its current form, if at all, so don’t rush out and lock in gains today.
However, none of these alone are enough to permanently derail the economy outside of another Covid variant immune from vaccines. Over the medium to long term, the path of least resistance is still higher. Companies and consumers are flush with cash and more stimulus packages are coming while the Democrats control all three chambers. Keep an eye on the above, but use any correction as an opportunity to purchase favored names in this bull market.
Comedians George Lopez and John Oliver are 60 and 44 today.
James Vogt, 610-260-2214