By Jim Allworth
The impact of disruptive geopolitical events on equity markets is usually short – measured in days – and the ground lost is regained fairly quickly. However, the deepest and most drawn out have been those which produced a sustained rise in energy prices.
As a result, the Russia/Ukraine war is going to have a debilitating effect on developed economies, some more than others. Higher fuel prices can act like consumption taxes, reducing the amount of disposable income available to spend on other goods and services, many having a bigger multiplier effect on overall GDP growth.
This is coming at a time when the U.S., Canada and several other developed economies were in the process of shifting from goods-driven expenditure to services-driven. Work-from-home and the unavailability of dining out, travel and other services resulted in heavier-than-normal spending on goods, pulling a considerable portion of future demand forward and leaving a weaker outlook for goods producers as spending swings toward the reopened services sector.
Weak manufacturing new orders are likely to be one result. This is sure to provoke debate about whether something worse than a slowdown is in the offing. We don’t think it is, despite the prospect of further central bank tightening. But with long-held estimates of above-trend GDP growth for 2022 now being revised lower as the impact of sanctions on already tight energy markets and inflation are factored in, there could be room for further volatility in equity markets over the coming months.
Despite this darker outlook, all seven of our leading indicators of U.S. recession continue to indicate no such downturn is in sight.
It’s worth remembering why getting the economy right is “Job One” for an investor. And the chart paints the picture clearly.
Compound growth rates since 1945: S&P 500 Index 7.3% per annum S&P 500 Earnings per Share 7.3% per annum U.S. Nominal GDP 6.3% per annum
The black line traces the path of the S&P 500 Index from the end of 1945 until today. It is plotted annually – that is, there is only one data point per year, eliminating all the volatility that goes on between each Jan. 1 and Dec. 31. While there are plenty of ups and downs, the rising trend of stock prices is clearly evident over the 76-year time span.
One can easily spot some of the most challenging bear markets:
But it is surprising how many of the other bear markets over that stretch (there were nine), not to mention other memorable market-shaking events, are hard to see when looked at this way. Here’s a partial list:
All of these are largely or entirely invisible on this 76-year chart of the S&P 500.
The green line plots S&P 500 earnings per share over the same 76 years. Since 1945, the S&P 500 has appreciated almost exactly as fast as the earnings per share of the index – both at close to 7.3% per annum. (Of course, shareholders did better than that collecting dividends along the way equal to about 2% per annum on top of the appreciation return.)
It would seem the best guide as to where the S&P 500 might be headed over the next few years would be a reliable forecast of earnings per share over that period.
Earnings rise at a rate mostly consistent with the growth rate of the economy. The red line plots the value of U.S. GDP produced in that same year. (This is the so-called “nominal” value, that is, with the effect of consumer price increases left in.)
This GDP plot is incredibly smooth. Despite the fact there were 12 recessions over the last 76 years, fewer than half show up as no more than faint ripples in this steadily rising line. The rest can’t be seen at all.
The paths followed by earnings and share prices are much bumpier, but for the most part hug the trend traced out by the economy. However, they have opened up a growth gap over GDP in the years following the financial crisis.
Part of this gap stems from the big U.S. corporate tax cut in 2017, which boosted index earnings by an estimated 12%. But more importantly over the past decade, foreign earnings have surged for the biggest capitalisation weights in the S&P 500, notably large-cap tech and tech-related. This has boosted index earnings per share but not U.S. GDP to the same degree.
Is the S&P 500 overvalued? Since the end of the financial crisis in 2009 to the end of last year the S&P 500 appreciated at a rate of 12% per annum while the earnings per share of the index grew by a startling 15.5% per annum. So if anything, it has been earnings that have been the over-achievers here more so than average share prices.
No big “value gap” has opened between share prices and index earnings as happened at the peak of the tech bubble. At its highs in December, the S&P 500 was trading at 21.3x the forward 12-month consensus earnings per share estimate. The pullback at the low brought that down to 17.6x forward earnings of $234 versus the 30-year average forward P/E of 17.4x.
Canada’s S&P/TSX Composite Index at 14.1x forward earnings estimates is below its historical average of 14.8x and at one of the deepest P/E discounts relative to the U.S. in history. European, UK and Japanese markets are trading at comparably low multiples.
In our view, valuations do not pose a large risk to investors as things stand. It would take a serious deterioration in the earnings outlook to push the market into a state of overvalued vulnerability. Such a deterioration would likely show up ahead of time in the leading indicators of recession. Our U.S. “recession scorecard” is showing no such weakness.
For a more detailed discussion of our outlook for financial markets, ask for a copy of our current issue of Global Insight.
Jim Allworth is co-chair of the RBC Global Portfolio Advisory Committee.
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