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Has the year-to-date increase in the S&P 500 been irrational?

With the S&P 500 Index gaining approximately 20% year-to-date, some clients have expressed concern about whether the U.S. equity move has been irrational. After all, employment is still 5.5 million jobs from its peak, Covid/delta remains an issue and debate rages on how permanent the current inflation spike may be.

As such, I thought you might be interested in the attached chart which makes a strong case that the year-to-date equity gains have actually been quite rational. The chart compares this year’s S&P 500 Index (orange) to the continuing rise in 2021 S&P 500 earnings estimates (blue) as 2021 has progressed. As you can see, the S&P 500 has closely tracked the better than expected earnings progress throughout the year. In fact, the S&P 500 has actually risen slightly less than the rise in earnings estimates. Basically, the S&P 500 has followed the improving fundamental outlook throughout the year.

Putting some color to the chart – At the beginning of the year, consensus earnings growth estimates for 2021 stood at a very robust 22% (coming off the 14% pandemic-induced earnings decline in 2020). The 22% original estimate prompted our optimistic 10%-15% S&P 500 return forecast outlined in our beginning-of-year forecast letter. But, it turns out the consensus 2021 beginning-of-year earnings estimates were way too low. As you can see from the rising blue line in the chart, estimates have risen steadily throughout the year and are now forecast to grow at 44% for 2021. Due to compounding, this works out to slightly more than a 20% improvement in earnings expectations since the beginning of 2021 – pretty mind-boggling. The reasons for the even-better than expected earnings growth rests primarily with 1) better than expected revenue growth as we recover from the pandemic and 2) to dramatic productivity improvement in corporations that were forced to change how they did business. Businesses have become much more productive due to technology enhancements and they have reconsidered what costs are actually necessary in their business. This has resulted in large increases to profit margins.

Does all this mean that we can’t have a 5%-10% market pullback? Of course not. It would be normal, rational, healthy and quite overdue – but would also not be particularly concerning. When should we be concerned about the next 20%+ correction? Larger corrections typically begin roughly 6-12 months before the onset of a recession. Fortunately, that still appears to be a far way off in the future.

As always, I would be more than happy to discuss this or anything else you may have on your mind.


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