A lot of people are complaining about how expensive the S&P 500 has gotten. Under normal circumstances, I would not be buying the market at 21X forward earnings either.
But I don’t buy the market. I buy the individual stocks that are growing fast enough to justify the price we pay. The steeper the growth trend, the less time we need to wait for their cash flow to catch up with high valuations.
Here’s a simpler way to say it: when the “E” or earnings side of the P/E calculation is climbing at a reasonable rate, even an unwieldy “P” or price starts looking a lot more reasonable.
And as for the market as a whole, forgive me for reminding you that these are not normal circumstances. The Fed’s free money has not gone away.
Chairman Jay Powell and company are still pumping $120 billion a month into the financial markets, while interest rates near zero ensure that anyone who wants to buy stocks on credit can do so.
When interest rates are low, free money naturally gravitates toward the stock market, crowding into companies that would otherwise look fully valued or even priced for a bubble. It’s that simple.
You don’t fight the Fed. However, you don’t blame everything on the Fed either. The real factor supporting the S&P 500 here on the edge of record territory and record valuations may be more surprising if you only follow the conventional Wall Street narrative.
Innovation Behind The Scenes
I’m talking about record earnings. Behind the pandemic and all the pain it caused, U.S. companies are now once again making more money than ever.
Innovation continued within the disruptions. The quest for efficiency continued. And as big companies got bigger, scale generated its own rewards in the form of better operating margins and wider opportunities to expand.
From that perspective, it’s almost as though the virus never happened to Corporate America. A few years from now, the virus will have receded deep into the rear view like a stretch of road we’d all rather forget.
We get through it. It hurts, but we get through it. And Corporate America has already gotten through it.
Yes, year-over-year comparisons are essentially meaningless. Because earnings plunged last year, the base is now artificially low, so growth rates look artificial and exaggerated.
That’s why I look at longer timelines to guide my sense of how fragile the economy truly is. From the end of 2019 (before the pandemic) to where I expect the market to be at the end of this year, earnings are tracking up 20% on the S&P 500.
Add my projections for 2022 and that two-year growth rate becomes 30% over a three-year period. Across that timeline, we’re looking at roughly 9.5% annual compound growth, which is pretty good on an extended basis.
After all, we didn’t get that kind of compound growth in 1995-1997, much less 1997-1999 . . . an era when the bulls had room to run so far that the occasional downswings felt more refreshing than ominous.
Growth Is Here . . . But Is The Price Nice?
Market math doesn’t consider human pain. The calculations are cold. When they say a stock has upside left to achieve, we buy. Otherwise, we wait for the price to come down.
Right now, the Fed has achieved boom conditions, at least on paper. While some of the free money may dry up late this year or early in 2022, that’s already built into my growth targets for the market as a whole.
And while 2021 will start winding down fast, 2023 is actually a long time away as far as the market is concerned. Right now, we are still farther from that future than we are from the pre-COVID world.
Time will change that calculation, moving 2023 and the Fed’s ultimate decision to raise rates closer day by day while the past recedes.
My question to you is simple. Are your favorite stocks growing fast enough to justify their multiples? If not, why do you own them?
The Fed’s boom is not echoing across all sectors equally. Companies that were hurting before the pandemic received massive support simply to remain solvent, while those that were doing well often saw their disruptive strategies accelerate in the upheavals.
Tech stocks, for example, are generating about 5 percentage points more growth per year in the 2019-22 period. Everything else being equal, that’s probably worth a 32X earnings multiple right now.
The sector as a whole currently commands a multiple closer to 28X earnings. It’s actually cheap relative to the broad market, adjusted for relative growth rates.
We can do this sector by sector and then drill down to individual stocks. The industrials no longer look so attractive at 21X earnings when you realize that the sector’s growth profile still lags the S&P 500 across the longer timeline.
And consumer stocks become a quagmire once you factor out Amazon.com Inc. (NASDAQ:AMZN). Suddenly growth evaporates, leaving investors chasing inflated multiples.
Who wants that? Not my subscribers.
After all, we aren’t prisoners of “the market as a whole.” And when stocks hit a wall, we can always trade options to squeeze profit out of stagnant or even falling seasons.