FINANCIAL MARKET UPDATE 4.13.2021

AUTHOR: JOSH JENKINS, CFA

STORY OF THE WEEK

EARNINGS SEASON IS SET TO BEGIN

Earnings season will kick off this week, with a handful of the big banks reporting results for the 1st quarter. The narrative in the market in recent months has been that progress in the nation’s vaccination program, coupled with extremely accommodative monetary and fiscal policy, should spark an explosion in business activity over the course of the year. Clearly, these optimistic expectations have found their way into asset prices, as the stock market appears to be somewhere between fully and richly valued. For the market to continue to justify current levels (or higher), reported results need to start reflecting the optimistic outlook.

To understand how business results impact stock prices, we can decompose stock returns into a variety of sources. A simplified model looks like this:

Return = dividends + earnings growth + change in valuation

Based on this equation, the return on a stock (or the stock market) is based on the dividends received, growth in earnings, and changes to how much investors are willing to pay for those earnings. Over the 12 month period ending on 3/31/21, the S&P 500 gained about 56%. During this time, dividends paid were slightly below 2%, while the growth in earnings was about 4% (according to FactSet). This suggests the bulk of the gain in the stock market has been due to a change in valuation. The chart below from JP Morgan supports this view.

The grey line in the above chart represents the forward P/E ratio, which is the current market price over the earnings that analysts are forecasting over the next 12 months. As you can see, the grey line dips dramatically in early 2020, only to shoot higher as the market recovered and subsequently hit new all-time highs. This demonstrates a substantial increase in valuation, generally referred to as ‘multiples expansion’ (the multiple of price over earnings (P/E) has expanded). A logical explanation for why the forward P/E increased so much is that interest rates are near historic lows, making the stock market look attractively priced in comparison. Investors, therefore, should be willing to pay a higher price for stocks. At some point, the Federal Reserve will raise interest rates again, however, and stocks will begin to look less attractive in comparison.

Another explanation for the lofty valuations is that investors are expecting earnings to increase dramatically in the not-so-distant future. According to data provided by FactSet, analysts are expecting rapid growth in YoY earnings over the next several quarters, which should be at least partially reflected in the forward P/E ratio. If investors are pricing in an even higher level of growth, it would make sense to see the forward P/E ratio rising. This can give rise to some confusing market reactions as companies publish their results. If the market is pricing in more growth than analysts were forecasting, you have a situation where companies can beat earnings estimates but subsequently sell-off in the market.

Ultimately, valuations tend to revert towards their long-term averages over time. With most measures of value currently well above average, there are two general ways this can play out. Either the large-cap stocks of the S&P 500 will see their prices correct and decline to a more sustainable level, or business results will live up to their lofty expectations. Investors will be watching earnings reports and gauging company outlooks closely for clues as to which direction we are heading.

WEEK IN REVIEW

  • The fight against COVID-19 has hit a few stumbling blocks in recent days. Setbacks include rising case counts, despite the accelerating pace of vaccinations and an announcement from the FDA that it is advising the J&J vaccine usage be paused out of an abundance of caution. The halt stems from six reported cases of blood clotting out of millions of people that have taken the vaccine.
  • The Labor Department published updated Consumer Price Index (CPI) data this morning. The report showed that prices increased by 2.6% YoY, the most rapid pace of price increases since August of 2018. The bulk of the price increases came from gasoline, which increased by 9.1% in March. The less volatile ‘Core CPI,’ which strips out food and energy prices, increased by 1.6% YoY. Investors will be watching the incoming inflation data very closely, given its implication on monetary policy. There seems to be a consensus that inflation will rise through the Spring, given the ‘base effect’ caused by the week reading current prices are being compared with. The main question is: whether higher inflation is transitory or here to stay.
  • Additional developments to watch for this week include a variety of Fed speakers on Wednesday, industrial production, capacity utilization and jobless claims on Thursday, and consumer sentiment and housing data on Friday.

HOT READS

Markets

  • Consumer Prices Rise More than Expected, Pushed By 9.1% Jump in Gasoline (CNBC)
  • Banks, After Bracing for Disaster, Are Now Ready for a Boom (WSJ)
  • FDA Halts Use of J&J Covid Vaccine Due to Rare Blood-Clotting Issue (CNBC)

Investing

Other

  • What Happens Now to the NFL Prospects Who Opted Out of Their Final College Season? (SI)
  • For the First Time, a Spacecraft Caught an Active Satellite to Extend its Life (CNBC)
  • Companies Can’t Stop Overworking (NYT)

MARKETS AT A GLANCE

Source: Morningstar Direct.

Source: Morningstar Direct.

Source: Treasury.gov

Source: Treasury.gov

Source: FRED Database & ICE Benchmark Administration Limited (IBA)

Source: FRED Database & ICE Benchmark Administration Limited (IBA)

ECONOMIC CALENDAR

Source: MarketWatch

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ABOUT THE AUTHOR

402.763.2967

jjenkins@lutz.us

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JOSH JENKINS, CFA + CHIEF INVESTMENT OFFICER

Josh Jenkins is the Chief Investment Officer at Lutz Financial. With 10+ years of relevant experience, he specializes in assisting clients with portfolio construction, asset allocation, and investment risk management. In addition, he is responsible for portfolio trading, investment research and thought leadership for the division. He lives in Omaha, NE, with his wife Kirsten.

AREAS OF FOCUS
  • Asset Allocation
  • Portfolio Management
  • Research & Data Analytics
  • Trading System Operation & Execution
AFFILIATIONS AND CREDENTIALS
  • Chartered Financial Analyst®
  • Chartered Financial Analyst Institute, Member
  • Chartered Financial Analyst Society of Nebraska, Member
EDUCATIONAL BACKGROUND
  • BSBA, University of Nebraska, Lincoln, NE

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