While some parts of the U.S. market still look expensive, the recent selloff has created buying opportunities among overlooked names.
As the Federal Reserve works to reestablish its inflation-fighting credentials, equity investors are rediscovering the impact that higher rates—and a higher cost of capital—has on company profits that are projected years, rather than months, into the future. To be clear, real interest rates are still well into negative territory, with the U.S. CPI running above 8% year-over-year, five points above the 3% yield on 10-year Treasury notes. Assuming the Fed stays the course, it will need, at a minimum, to raise rates above its preferred inflation gauge (core PCE), which is running at 5% annually. This should concern not only owners of long duration bonds, but also investors in ‘long duration’ growth stocks who might be tempted to bargain hunt following the recent carnage in the sector. Before doing so, they should consider what will happen to equities if the Fed fails to orchestrate a soft landing as it tightens monetary policy, tipping the economy into recession. Have stocks fallen far enough to build a sufficient margin of error? For market cap weighted benchmarks such as the S&P 500, the answer is no. Things could get worse before they get better based on current equity valuations.
U.S. equities have returned -17.8% year to date as measured by the Dow Jones U.S. Total Stock Market Index (DJUSTSM). The S&P 500 Index has done slightly better, down -16.3%, while the Nasdaq Composite has lost 25.7%. Our preferred measure of U.S. equities, the Barron’s 400 Index (B400), is down 17%. While painful, the drops in the S&P and Nasdaq aren’t as bad as they seem when looking back a year. In the last 52 weeks both indexes are down 4.7% and 13.3%, respectively. The total market index has lost 8% and B400 almost 9%. Small caps have suffered disproportionately, with the Russell 2000 Index down more than 20%.
As the reality of tighter monetary policies set in equity investors should ask themselves two questions:
- In a slower economy, and an environment of high inflation and higher interest rates, where will growth come from?
- How much am I willing to pay for such growth if valuations still seem elevated and a margin of error is needed in case of a recession?
Is there still growth in U.S. equities?
Yes, and plenty of it. While it is true that growth expectations across most segments of the market have come down since the end of last year, the most recent earnings season provided plenty of evidence of where growth will come from for the remainder of 2022. Earnings guidance among public U.S. companies for fiscal year 2022, and how analysts adjust their estimates based on them, will go a long way towards determining the market’s direction in the back half of the year. We therefore looked at fiscal year earnings estimates for all companies in the S&P 500 and the Barron’s 400 today relative to where they were three months ago, well before the most recent earnings season started, to better understand how companies have adjusted their expected fiscal year figures in an environment of rising rates, pervasive inflation, and geopolitical conflict.
The picture for S&P 500 companies isn’t very flattering. Consensus analysts’ estimates for fiscal year 2022 earnings for 218 members of the S&P 500, almost 44% of the index’s constituents, are lower today than they were three months ago. Their average consensus estimate decline was -9.2% (it is marginally higher if adjusting for the weight of the companies in the index). For 52 of them, the latest estimate for full year earnings is at least 10% lower than it was three months ago. Meanwhile only 75 of the index’s constituents have seen their fiscal year estimate rise by double figures in the last three months. Sixteen of these are Energy companies. Perhaps most worrisome is the fact that all but three of the index’s ten largest constituents, which account for almost 30% of its weight, have lower fiscal year 2022 EPS estimates today than they did three months ago. The three that have higher full year estimates today are Apple, Berkshire Hathaway, and Nvidia.
Across the entire index, fiscal year 2022 EPS estimates are, on average, only 2% higher today than they were three months ago. The median increase is just 0.3%, with more than six months still left to go before the end of the year. While much could change for the better by then, especially if inflation does come down as quickly as the Fed hopes, much could also go wrong, pushing estimates further down and with them the share prices of companies with rapidly declining guidance.
For the Barron’s 400 Index the story is quite different. Ninety-two of B400’s constituents have fiscal year 2022 estimates that are lower today than they were three months ago. This represents 23% of the index’s constituents; however, the average decline for these companies was -5.3%. Only twelve of these companies have seen their fiscal year EPS estimate decline by double digits. On the other hand, 140 of B400’s constituents have full year estimates that are at least 10% higher today than they were three months ago. Across the entire index, fiscal year 2022 estimates today are, on average, 12.3% higher than they were three months ago. This is six times the average of the constituents of the S&P 500. Their median increase, by the way, is 5% compared to 0.3% for the S&P. The stark contrast between both indexes is displayed in Figure 1.
Figure 1. Change in FY 2022 EPS Estimates for S&P 500 and Barron’s 400 In the Last 3 Months
|S&P 500 Index||Barron’s 400 Index|
|Fiscal Year 2022 EPS Estimate – 3 Mo. Change (avg.)||2.0%||12.3%|
|Fiscal Year 2022 EPS Estimate – 3 Mo. Change (median)||0.3%||5.0%|
|Percentage of constituents with double-digit decreases||44%||23%|
How much should you pay for growth?
Despite falling more than 16% this year, the S&P 500 is still trading, on average, at 25 times forward earnings, based on the next fiscal year estimate across all constituents. Meanwhile, B400 constituents are trading at only 14.5 times forward estimates, a multi-year low. B400’s median is an even lower 11.4 times next fiscal year earnings per share estimates. Put differently, half of B400 constituents are trading at distressed valuations even though less than a quarter of its constituents have lower full year earnings estimates today than they did three months ago.
A better way to look at the opportunity cost of owning equities today is by using the earnings yield, or the inverse of the P/E ratio. This is particularly useful in an environment in which holding cash has returned a negative 8.5% in the last year based on the eroded purchasing power of money thanks to inflation. For bond investors the pain has been no less than for equity investors, with the Bloomberg U.S. Aggregate Bond Index down 10% for the year. Income investors relying on bonds for their coupon are not only getting paid in dollars with diminished purchasing power, but they have also suffered capital losses as rising rates have knocked down the face value of their investment. A bond investor considering Treasury notes today would not only have to settle for a negative real rate of return of about 5% (except for TIPS that would guarantee an inflation-adjusted coupon), but would also face significant duration risk in a rising rate environment.
While equity investors looking for income may focus on dividend yields, those focused on capital appreciation should pay closer attention to the earnings yield, especially in an inflationary environment. As the inverse of the price to earnings ratio, earnings yield essentially represents what every dollar invested in a profitable company produces in earnings, which will raise the company’s enterprise value over time. Similar to bonds, whose yield moves inversely to price, earnings yield may be used to gauge when a stock has fallen so much that its yield becomes too attractive to ignore.
At the end of 2021, the S&P 500 Index traded at an earnings yield of 4.5%. Following this year’s drawdown, you would assume the yield would have risen significantly as higher earnings, lower prices, or both make the index more attractive. However, the index’s earnings yield has barely budged, up to 4.6% today, on average. The median yield is even lower, at 4.1%. The Barron’s 400 Index, on the other hand, was already cheap when the year started, yielding 8.9%. As stock prices have declined, and as earnings have improved, its earnings yield has risen to 9.3% today. This is not only twice as high as the yield on the S&P 500, but it is also a full point ahead of the rate of inflation in the U.S., running at 8.3% annually. Figure 2 illustrates the difference in valuations today between the S&P 500 and the Barron’s 400.
Figure 2. Valuation Metrics for S&P 500 Index and Barron’s 400 Index
|S&P 500 Index||Barron’s 400 Index|
|Earnings Yield – Average||4.6%||9.3%|
|Earnings Yield – Median||4.1%||7.5%|
|Forward P/E Ratio – Average||25.2||14.5|
|Forward P/E Ratio – Median||17.9||11.4|
Keeping in mind that equities have traditionally been viewed as an inflation hedge (a company’s revenues and earnings also rise with inflation), the higher earnings yield of the B400 suggests that the index is better positioned than the S&P 500 to handle the current inflationary environment and provide a cushion in case of a policy error. Investors looking to build a position in equities today would be exposed to far better companies with the B400 than the exposure they would get from the market cap-weighted S&P 500 benchmark, which not only has lower earnings growth prospects, but is also exposed at the top to expensive technology names.
Bottomline: Investors looking to buy U.S. equities at historically favorable valuations should go beyond the growth vs. value debate and consider companies with handsome growth prospects, without overpaying for their shares. They should also consider cushioning their exposures (via an additional earnings margin) in case the Fed’s euphemistic ‘soft landing’ turns into a recession that, coupled with high inflation, leads to an erosion of corporate earnings power.
 This is not an endorsement or recommendation to buy a security. MarketGrader and Barron’s earn licensing fees paid from the management fee collected by the fund manager of the Barron’s 400 ETF.
 All returns are price-only through May 9, 2022. Sources: WSJ, MarketGrader.