For all the hand-wringing over the direction of interest rates and the Federal Reserve’s next move, the performance of U.S. large-cap stocks may hinge more on company earnings than “any macroeconomic factor,” according to DataTrek Research.
Should S&P 500 earnings end up at $240 a share in 2022, or 10% above current estimates, then “we don’t care if the Fed raises rates 4 times next year and 10-year Treasuries end up yielding 3.0 percent,” wrote Nicholas Colas, co-founder of DataTrek Research, in an emailed note Monday. “None of that will likely matter much to stock prices.”
Instead, “just look at this year for proof that earnings can trump pretty much anything else,” Colas said in the note. The S&P 500 index
has soared to more than 60 record closing highs this year, with gains of almost 25% so far in 2021, according to FactSet data, based on Monday afternoon trading.
The third quarter is shaping up to be a record for S&P 500 earnings per share — despite concerns over inflation, labor shortages and supply-chain issues, according to DataTrek.
The S&P 500 earned $53.60 per share in the third quarter based on 92% of companies reporting, beating Wall Street estimates by 10%, said Colas. The U.S. stock index is up about 9% since the end of September, he said. “What else do you need to know?”
“Analysts thought there was no way the S&P could out earn Q2, but they were wrong—and badly so,” said Colas. “The upside in U.S. corporate earnings this year is entirely responsible” for the S&P 500’s gains so far in 2021.
Meanwhile, investors are watching for timing on when the Fed might raise its benchmark interest rate from near 0%, particularly amid concerns over the spike in inflation this year. While increasing rates can help tame inflation, the Fed has repeatedly expressed the view that the jump in the cost of living during the pandemic should prove transitory.
“Fed Funds Futures are giving the FOMC the green light to materially change its expectations for future rate policy,” said Colas, pointing to the Federal Open Market Committee’s policy meeting scheduled for mid-December. “Fed Funds Futures are ratcheting up expectations for 3+ rate hikes next year,” he wrote.
Investors also have been watching the direction of the yield on the 10-year Treasury note
amid concern that a rise in the benchmark rate would particularly hurt valuations of high-growth, technology stocks. The 10-year Treasury note was yielding around 1.62% Monday afternoon, up about more than 3 basis points, but still well below the 1.75% rate seen at the end of March.
Wall Street analysts think the fourth quarter of this year and the first quarter of 2022 will show lower earnings compared with third-quarter results, according to the DataTrek note.
DATATREK RESEARCH NOTE
“That seems overly pessimistic given continued economic growth and the now-proven ability of U.S. companies to offset input cost inflation with pricing power of their own,” said Colas. “Our own take is that Q4 2021 will be substantially better than analysts’ expectations.”
Economic growth in the U.S. and globally should remain “more than robust enough” for companies to hold margins near 13%, which is the average of the last two quarters, according to DataTrek. Growth in U.S. gross domestic product, the official scorecard of economic health, is expected to accelerate to 4% in the final three months of 2021, from just 2% during the third quarter, the note shows.
“We strongly suspect many companies have been over-accruing expenses this year as they report quarterly earnings,” said Colas. “As companies true up their books and consider accrual rates for 2022, Q4 should see a bump in margins and therefore reported earnings.”
Meanwhile, Wall Street analysts’ estimates for S&P 500 earnings for 2021 have gone up almost every week this year, according to the DataTrek note, citing FactSet data. “Estimates for 2022, some recent squirreliness aside, are following the same pattern,” said Colas, describing the trend lines higher as “remarkable.”
While DataTrek said “the direct link between better earnings and higher stock prices is clear,” the research firm’s note included a word of caution:
“At current valuations—21.1x estimates for 2022 earnings—there is no room for error when it comes to evaluating future earnings power.”