Earnings Momentum Trumps Overblown Worries About Inflation And Valuations

Stocks are once again challenging all-time highs as the forward earnings estimates are being raised at a historically high rate in the wake of another impressive earnings season that blew away all consensus expectations. YTD through May, index total returns were strong across the board, including +12.7% for S&P 500, +6.6% for Nasdaq 100 (as mega-cap growth endured the brunt of the Value rotation), and +15.2% for Russell 2000 small caps. The strong earnings reports have given rise to further upgrades to forward sales and earnings from a highly cautious analyst community, many of whom are still concerned about COVID variants, supply chains, inflation, and Fed tapering, among many other worries.

Nevertheless, prices have not gone up as fast as earnings, so valuations have receded a bit, with the S&P 500 falling from a forward P/E of 21.8x at the start of the year to 21.2x at the end of May (i.e., -2.8% versus a total return of +12.7%). Cyclicals in particular have seen this same trend since they were largely bid up on speculation. For example, Energy (XLE) is up +39.2% YTD, but its forward P/E has fallen from 29.2x to 17.2x (-28.4%). With plenty of cash on the sidelines, many investors likely are holding back and hoping for a solid pullback rather than deploy cash at what may still appear to be elevated valuations and stretched technicals, as they move past a speculative investing mindset and into a more fundamentals and quality-oriented stage. While more speculative asset classes like SPACs and cryptocurrencies already have endured a pretty severe correction (driven by negative press or tweets from influential personalities), stocks really haven’t yet seen a healthy cleansing.

When the April YOY CPI reading came out on 5/12 at a surprisingly high +4.2%, stocks were expected to selloff hard, led by mega-cap growth stocks. But instead, they quickly gathered conviction and resumed their march higher. Small-cap value (which is dominated by cyclical sectors like Financial, Industrial, Materials, and Consumer Discretionary) in particular remains quite strong this year as the Value rotation continues in the face of an expansionary/recovery economic phase, unabated government support and largesse, and a continued productivity boom. And with GDP growth accelerating, particularly as the economy fully reopens and hobbled global supply chains are mended or rerouted, it is likely that the Street’s forward earnings estimates (even after the recent upgrades) are still too low, which means stocks should have more room to run without relying upon multiple expansion, in my view.

So, two questions seem to linger on everyone’s mind: 1) how might inflationary pressures impact economic growth and the stock market, and 2) are stock valuations overdone and at risk of a major correction? I tackle these questions in today’s post. In short, I believe earnings momentum should win out over overblown inflation worries and multiple contraction as we embark upon a multi-year boom (a “Roaring ‘20s” redux?) – but not without bouts of volatility.

With no clear path for runaway inflation and given the recent rotation out of the Growth factor, investors now seem to be adding exposure to both secular and cyclical growth – which is what my regular readers know I have been suggesting and what Sabrient’s GARP portfolios (including our flagship Baker’s Dozen) reflect.

In this periodic update, I provide a comprehensive market commentary, offer my technical analysis of the S&P 500 chart, review Sabrient’s latest fundamentals-based SectorCast quant rankings of the ten US business sectors, and serve up some actionable ETF trading ideas. To summarize, our sector rankings reflect a solidly bullish bias, the technical picture is still long-term bullish (although in need of further near-term consolidation), and our sector rotation model retains its bullish posture.


The chart below illustrates various performance differentials since the value rotation began on 11/1/2020 by comparing Invesco S&P SmallCap 600 Pure Value (RZV), iShares Russell 2000 (IWM), SPDR S&P 500 Trust (SPY), Invesco Nasdaq 100 (QQQ), and Invesco S&P 500 Pure Growth (RPG). You can see that the growth and large-cap-oriented SPY, QQQ, and RPG continue to be bunched together at the bottom. However, since mid-February, the broader small-cap index (IWM) has essentially gone sideways while small-cap value continues to surge higher. According to S&P Dow Jones Indices, most style factors posted gains during May, led by High Beta and most Value-oriented strategies, while Growth and Momentum both declined. Most sectors posted gains, led by Energy. The CBOE Volatility Index (VIX) closed the month at a relatively complacent 16.76 after spiking mid-month to nearly 29 following the latest CPI reading.

ETF performance comparison

At the height of the pandemic, businesses conserved cash by slashing spending on Capex and R&D, as well as dividends, buybacks, and M&A. Moreover, they leveraged the ultra-low interest rates to raise cheap capital and bolster liquidity. Aggregate corporate cash surpassed $2.1 trillion, up more than 30% from the end of 2019. Fast forward to today, we see surging GDP growth and business confidence, as well as soaring revenues, earnings, and profitability.

The Commerce Department’s BEA announced on 5/28 its second estimate for Q1 2021 GDP growth at an annual rate of 6.4% (unchanged from preliminary estimate, and up from 4.3% for Q4 2020), which would be the largest growth rate since 1984 (next update will be 6/24). Moreover, Q1 ended with the month of March showing incredible surges in household income (21.1%, the highest reading ever recorded), personal savings (27.6%), and consumer spending (8.1%). Looking ahead, the Atlanta Fed’s GDPNow model is forecasting Q2 2021 GDP will show a robust annual growth rate of 10.3% (as of 6/1, with next update coming on 6/8) on the backs of strong consumer spending, a manufacturing backlog, and inventory build.

On the other hand, a swelling US current-account deficit has many fretting about a weakening dollar and perhaps its imminent demise as the world’s reserve currency. The median economist estimate expects the current-account deficit to hit 3.6% of GDP this year, which would be the largest since 2008. Some experts think the dollar is too expensive such that non-US assets are increasingly attractive, causing capital to rotate out of US fixed-income and equity markets. However, in my view, the huge gap between imports and exports was driven by US money-printing bolstering consumer demand while manufacturing activity was slowed or shut down.

Moreover, a robust US economy and rising imports do not necessarily lead to dollar weakness mainly because our capital account continues to show a huge surplus, as foreign investors crave access to the innovation and disruption of US companies, particularly in the Tech sector. Yes, the US is printing dollars (and monetizing debt) at a ridiculous rate, but other major economies are doing so as well, and the US is always looked upon as a global safe haven in times of uncertainty (which includes today’s unprecedented circumstances).

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Disclosure: At the time of this writing, among the securities mentioned, the author held protective puts in SPY.

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