Key earnings week and a shallow equity market
Head of Equity Strategy
Summary: This week will be the first real litmus test on sentiment vs earnings reality and the outlooks from companies. Many interesting companies such as Netflix, Intel, Biogen, Delta Airlines, American Express and Boeing will report earnings this week. Maybe bad earnings are what finally get investors to realize that they are buying equities at very expensive levels here. No matter whether we use the dividend futures market or expected GDP growth numbers and how they have translated into EPS growth in the past we get to the same conclusion. The equity market is very expensive here and the risk-reward ratio is not attractive.
Unprecedented monetary and fiscal responses to a 100-year event all calls for humility when it comes to predicting the future. At best we can guess what will happen, but we are so out in the tails in terms of what we are observing that we have little prior data to inform our choices. However, in this equity note we outline the key focus points for this week’s earnings and why we still believe this is a shallow equity rally.
But the key observation for everyone is the staggering comeback for US technology stocks with the NASDAQ 100 climbing on Friday into positive territory for the year. If anyone told you in early January that we would have a global pandemic and the worst economic shock in 90 years but the NASDAQ 100 would still be positive for the year you would have laughed. But the strong sentiment could easily stop the next two weeks starting with a reality check on earnings. This week the EU summit could also pose a downside risk for equities as the Italian PM Conte has doubled down on his call for joint euro bonds to fight the crisis. It looks increasingly like the pro-Europeans are only pro Europe in good times when trade is flowing and when redistribution is needed to save the system the wealthy countries hold on to their gains.
Last week marked the first week of the earnings season and that was a shocker for the market as banks posted the highest level of provisions for loan losses since 2008. S&P 500 financials ended the week down 4% and dividend futures immediately halted their rise as weak banking earnings are an omen for future profitability. Main Street sits on the balance sheet of banks and thus weakness there is an overall weakness of the economy – more on that later.
But the equity rally has been led by technology companies and thus this rally might be punctuated if technology companies fail to live up to investor expectations. We believe that the market is mispricing Facebook and Alphabet (Google’s parent company) as online advertising is down massively from February levels as many companies including the entire travel industry (which is a sizeable ad spender online) have pulled advertising due to the many lockdowns in the US and Europe. In our view the market will be very surprised about how hard Facebook and Google has been hit. It will reset valuation multiples but rest assured on the other side of COVID-19 online advertising will be a high growth business again.
Among this week’s earnings we would like to highlight IBM (today) as the 350,000 employees company has a big footprint on corporate spending on technology infrastructure and thus is a good litmus test on corporate spending in the US. Tomorrow the big one is Netflix which is enjoying investors appetite for entertainment stocks – key here is the US segment because rising unemployment could be a risk to their subscriber base in the US unless streaming TV is now like the utility bill. Tomorrow we also get earnings from the first P&C insurer (Chubb) which will give insights into whether the sell-off among insurance stocks has been too much. Wednesday we get the first biotechnology earnings from Biogen which is a key risk to the health care sector which has been one of the best performing sectors during COVID-19. Delta Airlines also report on Wednesday which will undoubtedly be sad reading but hopefully there is some light at the end of the tunnel. Key focus for Delta Airliners is the balance sheet damage as that feeds directly into default risks etc. On Thursday we have Intel which will give the first glimpse of end-user demand in the computing industry and Credit Suisse will also report providing the first and most likely shocker to European investors. Friday we have earnings from American Express which could be very bad given the consumer credit card provisions delivered by banks last week. Boeing is also reporting on Friday and could be the positive surprise despite the negative backdrop from airliners as the company is restarting 737 Max production in May. Finally we have many Swedish earnings this week so we expect volatility in OMX this week and we believe Swedish earnings could be the first full picture disappointment for investors as Sweden’s procyclical companies must be hurting big time during these lockdowns.
One of our new indicators to watch is US financials vs FANG+ stocks as this is essentially Main Street vs Silicon Valley. As long as financials continue to underperform the real economy is hurting on a relative basis to the technology sector. With the technology sector already being 25% of the S&P 500 and 30% if the media companies sitting in the Communication Services sector are added. There is a limit to how much this sector can eat of overall profits before it becomes unsustainable for the entire equity market and economy. If financials suddenly outperform it’s likely a good sign for the economy but bad short-term for the equity market.
We have highlighted the newly dividend futures market (actively traded since 2015) before as one of the most interesting markets to guide investors about their valuation models and expectations for future profitability. Unfortunately few seems to be using its signal. Otherwise the S&P 500 would be trading at a very different level. Due to the current volatility we use the 5-day average of the volume weighted average price as our point estimate for dividends in 2021 in the S&P 500. This number is currently $43.10. With Friday’s close in the S&P 500 that equates to a dividend yield of 1.5%. Of all the observed dividend yields since 1995 this puts the S&P 500 in the 17% percentile of the distribution on dividend yield. This is a dividend yield you expected in 1999 when we all thought that we had a ‘new economy’ and growth was high. But not in 2020 with a global pandemic raging and an economic shock as big as the 1930s.
Extending the analysis to earnings yield derived by applying the range of payout ratios since 1995 we get a much richer valuation picture for the S&P 500. Based on the 2021 expected dividends we get to a fair value of the S&P 500 of 2,387 which is 17% lower than the current level. But that assumes the probability weighed average is the right price. It would still mean a S&P 500 trading 18x forward EPS (using our EPS estimate from the model explained in the next section) which is high coming out of a deep recession.
As the dividend futures curve shows the future expectations for earnings and dividends are very negative. But with good reasons. It took four years and a quarter for EPS after the Great Financial Crisis to return to its peak in Q2 2007. It could take longer this time as the economic shocks cascades into multiple crisis across a sovereign crisis in many weak emerging market countries, a new EU crisis as Germany and Netherlands reject the idea of joint euro bonds and credit default globally.
Using data since 1954 we have created a EPS model with only two inputs. GDP growth and change in GDP growth. Based on Wall Street projections for GDP growth until Q4 2021 we have created a base case scenario (dotted lines) and then a much worse scenario (solid lines) looking more like a tilted L-shape recovery instead of the V-shape recovery that everyone is believing will happen. Using the average of the two scenarios’ 50% percentile EPS figure for Q4 2021 we get $131.47 which with Friday’s close in S&P 500 equates to a forward P/E multiple of 21.9. Based on the current dividend futures it looks like the EPS trajectory will be closer to the 25% percentiles reflecting the severe downside dynamics and spill over effects. Using the average here we get $95.42 in Q4 2021 which means that the S&P 500 is trading at 30.1 on forward P/E. Whether you use our EPS model or the dividend futures market they both point to the same conclusion. That the US equity market is very expensive at this point. The risk-reward ratio is simply not attractive.