The bears are still theres. As equity markets march relentlessly higher on vaccine rollouts, economic reopenings, catch-up growth and stimulus, a few growls can still be found. Deutsche is one:
Equities have historically traded closely with indicators of cyclical macro growth such as the ISMs (correlation 73%). Growth (ISM) typically peaks around a year (10-11 months) after recession ends, right at the point we would appear to be. A majority of historical peaks in growth (two thirds) were inverted-V shaped, while the rest saw the ISM flatten out at an elevated level. The S&P 500 sold off around growth peaks by a median -8.4%, but even episodes which saw the ISM flatten out rather than fall, saw a median -5.9% selloff.
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Very near term, we expect equities to continue to be well supported by the acceleration in macro growth, and see buying by systematic strategies and buybacks driving a grind higher. But we expect a significant consolidation (-6% to -10%) as growth peaks over the next 3 months. Our house economics forecast implies a flattening out of the ISMs at elevated levels beginning in Q2(64) and continuing into Q3 (63). There are a number of considerations though that suggest the monthly ISMs peak more sharply over the next 3months and slow in keeping with the historical inverted-V shaped pattern. We look for discretionary investor equity positioning to be pared with a peak in the ISMs and do not expect retail to buy the dip. We then see equities rallying back as our baseline remains for strong growth but only a gradual and modest rise in inflation. Further out, late summer and into the fall we see the risks to inflation as being to the upside and discuss how the market is likely to respond.
- Historically inflation has unambiguously and robustly beennegative for equities. It has historically been the main driver of cycles in the equity multiple. So far, with equity multiples running high,the market looks to have priced in little or no risk of higher inflation.
- Why does inflation matter for equity multiples? For the same reason that higher inflation leads to higher bond yields as investors demand a higher nominal return as compensation. Indeed the S&P 500 earnings yield (inverse of the multiple) and the US 10y yield moved in tandem during the 1968-1995 inflation up and down cycles.
- How much has inflation mattered? Our estimates imply that a 1pp increase in inflation compresses the equity multiple by around 1point and so from current levels implies a relatively modest marketpullback of -5%. But what will be key to the market reaction iswhether the market believes the rise in inflation sustains oraccelerates and the Fed’s reaction to it. We note that the most recent fiscal package has resulted in a debate about inflation riskseven before the Fed has embarked on any normalization of itspandemic policy response. This is very unusual historically asinflation concerns generally arise late in the business cycle.
- But a Fed response to contain inflation is likely to see a muchlarger pullback.Key to the equity market reaction to the widelyexpected temporary rise in inflation this summer will be whetherand how the Fed reacts. Any Fed change to bringing policynormalization earlier on concerns about higher or rising inflationare likely to see a large pull back. Since historically rate hikes tooffset inflation typically occurred late in the business cycle andtypically ended in recessions, the market may well begin to price inthe end of the cycle with a typical -20% decline.
Another is BofA:
Blowout earnings ≠ blowout market
On the heels of our economists’ GDP upgrade and positive guidance from companies, we raised our 2021 EPSestimate. Why no change to our target of 3800 by year-end? The correlation between returns and quarterly/annual earnings growth is low,at just 12%/22%-a host of other factors matter as well. Over the past month, only one of our five target models has grown more bullish on stocks (which is also based on earnings), more below. Our 2021-22 EPS forecasts of$185 and $205 imply ~2900-3200 on the S&P 500based on the average forward P/E of 15.5x vs 20x-22xcurrently implied by today’s price level which is in the top ~90th%tile.In 4Q, companies that beat on earnings underperformed in the subsequent days, suggesting the market was pricing in blowout earnings. With record inflows into stocks in 1Q, optimism has accelerated.
1)Sell Side Indicator <1ppt away from euphoria: Our contrarian measure of Wall Street’s bullishnessis<1ppt away from a“sell” signal. Last cycle, when it was this close to a“sell”(May 07), the S&P dropped 7%over the next 12mths. Note, we’re not calling gor a full-fledged bear market (just 58% of our“Bear MarketSignposts” have been triggered vs. 80%+ ahead of prior bear markets, Exhibit 26). Another measure of Wall Street bullishness: we’re tied for last place among strategists’ forecast for the S&P 500 (Source: Bloomberg).
2)S&P 500 valuation indicates paltry (2%p.a.) returns over the next decade: Valuation is almost all that matters over the long-term (~80% explanatory power, Exhibit 18). With the increase in valuations in April, this framework yields 10-yr price returns of just 2%/year (versus 5% in Nov., and 10% 10 years ago).
3)Outsized (2+ std dev) returns precede losses 75% of the time: TheS&P 500 posted12m returns of+54% through March, marking thebest12m since 1936, the third highest on record, and 2.3std.dev. above average (Exhibit 2). Two+standard deviation moves have only happened four other times since 1928, with losses occurring over the next12 months in three of the four cases (avg. next 12m ret. of-4%).
4)Fair Value model spits out S&P 500 3635 (but sensitive to inputs): This is based on our 2022cyclically-adjusted earnings forecast of $173and our equity risk premium(ERP) forecast of 425bp by year-end (vs.398bp today) as 2H shifts to concerns about peak earnings and peak stimulus. See Exhibit 4.
5)ERP dropped below 400bps–a contrarian negative signal: This is only the third time since the global financial crisis that the ERP dropped below 400bps. Two prior instances were Jan 2018 (399bps) and Sep 2018(394bps), after which the S&P 500 posted-10%and-20% peak-to-trough declines, respectively (Exhibit 6).
A few points:
- Of course stocks are going to correct. Don’t panic!
- There is excellent growth ahead after the catch-up boom that will run all of this year thanks to the US fiscal pulse.
- The ERP is the key to whether Wall St gets spooked and that hangs on yeids. My own view is that US inflation will firm up but be contained as China slows sharply in 2022 and commodities crater with EMs.
- This is still a good outlook for the US economy and stocks but is increasingly poor for Australian stocks.