Earnings Momentum Trumps Overblown Worries About Inflation And Valuations

Certainly, this would be good news for China, whose growth depends upon affordable raw materials, commodities, and food. So, while the US Fed is trying to stoke inflation, China has been making policy moves to control commodity prices. Nevertheless, I think a nascent commodity “Supercycle” is still likely, albeit slower and more gradual for the longer term than many observers have predicted – which was mostly their knee-jerk reaction to the price spike in construction materials (like lumber and copper) caused by a combination of surging demand and supply chain disruptions (plus some ransomware attacks, to boot). Perhaps this more temperate view of inflation is why Chinese stocks have been catching a bid lately.

Powerful earnings momentum justifies valuations

As I said in my prior post, after a big speculative recovery rally characterized by multiple expansion rather than earnings growth, investors are now looking for stocks to justify their elevated valuations with actual earnings growth (as well as solid earnings quality). In fact, earnings had to come in much better than expected, as forward valuation multiples stabilize and even recede a bit. Thankfully, Q1 was the best quarter in several years, as about 87% of the S&P 500 companies beat expectations with an aggregate YOY EPS growth rate of 52% (albeit against easy comps in Q1 2020) and 76% beat revenue estimates. In other words, earnings are rising to meet prices rather than prices falling to meet earnings.

Assuming aggregate S&P 500 earnings of $192/share for full-year 2021 and $220/share in 2022 along with a current index level around 4,200, the full-year 2021 P/E is about 21.9x and the 2022 P/E is 19.1x. Thus, if stocks are going to have more upside potential without multiple expansion, earnings for the rest of 2021 and 2022 will need to be even better than the Street’s forecasts, which I think is a good bet. Because analysts still seem reluctant to go too far out on a limb, I think earnings indeed will continue to beat expectations – so long as there is no sudden resurgence in the pandemic here at home or a sustained surge in inflation that causes the Fed to tighten. But again, I think those scenarios are unlikely. That’s not to say there aren’t hurdles ahead – not the least of which is the surge in cases of a highly contagious COVID strain in key manufacturing countries like India and Vietnam. But even so, I think earnings expectations are understated.

Final comments

In my view, it was normal to see record low-interest rates last summer given the economic shutdowns, and as the economy reopens, interest rates are simply returning to pre-pandemic levels. Furthermore, relatively higher yields in the US attract global capital. At the same time, the Fed continues to pledge its support – indeed, I think it may even implement yield curve control (YCC) to help keep longer-term rates in check.

In its response to the Financial Crisis, Fed policy primarily served to recapitalize banks rather than boost the economy such that value stocks struggled while less capital- or labor-intensive growth companies thrived (due to an ability to maximize productivity in a so-called "jobless recovery”). In contrast, the Fed’s response to the pandemic was targeted specifically at boosting economic activity since banks were already healthy, which has been favorable for value stocks and cyclical sectors.

And as for inflation, although the headline CPI reading of 4.2% sounds ominous, much of it can be explained away as temporary. And with so many early-cycle tailwinds, including Fed support, low-interest rates, record levels of business and CEO confidence, strong earnings momentum, rising productivity and profitability, and robust consumer spending, stocks appear to have plenty of runway.

Thus, I continue to believe the best course of action is to remain bullish and invested in both cyclical and secular growth equities. Given that many of the big momentum Tech stocks that prospered from WFH and other pandemic impacts have pulled back, some of them are displaying attractive valuations once again. Regardless, I expect fundamental active selection, strategic beta, and equal weighting will continue to outperform the cap-weighted passive indexes that have been so hard to beat over the past few years. This should be favorable for Sabrient’s enhanced growth-at-a-reasonable-price (aka GARP) approach, which combines value, growth, and quality factors while striking a balance between secular growth and cyclical/value stocks and across market caps.

SPY Chart Review

The SPDR S&P500 Trust (SPY) closed Wednesday 6/1/2021 at 420.33. Looking at the 6-month daily chart below, SPY is challenging all-time highs and trying to avoid forming a bearish double-top in a 1-month sideways channel. The longer-term rising channel (from the start of the Value rotation on 11/1/2020) remains intact, and the current price action falls right in the middle of it. Oscillators RSI, MACD, and Slow Stochastics are all in neutral positions and could go either way from here. The bottom of the long-term rising channel has coincided with the 50-day simple moving average (SMA) in providing reliable support this year. Other support levels include bullish price gaps at 410 and 400 and the bottom of the sideways channel around 405.

SPY daily chart

Looking at the monthly chart below, it is quite a bit more ominous, with price quite extended above the 20-day (and all other) moving average. The month of May formed something close to a hanging man candlestick, which is quite bearish. Typically, the greater the divergence from moving averages, the greater the correction. However, it is possible that price could simply consolidate during the summer while waiting for the moving averages to catch up. I suggest being vigilant about a potential correction – although I believe it would be a great buying opportunity.

SPY monthly chart

Latest Sector Rankings

Relative sector rankings are based on our proprietary SectorCast model, which builds a composite profile of each of over 900 equity ETFs based on bottom-up aggregate scoring of the constituent stocks. The Outlook Score employs a forward-looking, fundamentals-based multifactor algorithm considering forward valuation, historical and projected earnings growth, the dynamics of Wall Street analysts’ consensus earnings estimates and recent revisions (up or down), quality, and sustainability of reported earnings, and various return ratios. It helps us predict relative performance over the next 2-6 months.

In addition, SectorCast computes a Bull Score and Bear Score for each ETF based on the recent price behavior of the constituent stocks on, particularly strong and weak market days. A high Bull score indicates that stocks within the ETF recently have tended toward relative outperformance when the market is strong, while a high Bear score indicates that stocks within the ETF have tended to hold up relatively well (i.e., safe havens) when the market is weak.

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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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