In an article I read recently, Bloomberg reported that:
“…..71% of respondents in a Bloomberg News survey expect equities to rise [in 2023], versus 19% forecasting declines. For those predicting gains in 2023 in equities, the average response was a 10% return.”[1]
The graph below, extracted from that article, provides a historical perspective of equity returns.
The MSCI All-Country World Index is a global index, so it is broader scope than the S&P 500 (although US stocks make up circa 63% of the index). Nonetheless, the point is that a majority of investors expect equities to do better in 2023 than in 2022.
The lack of reliability in predicting stock prices one-year forward
According to an article in the New York Times on Dec 16th (“Forget Stock Predictions for Next Year, Focus on the Next Decade”), the consensus view of Wall Street strategists always turns out to be wrong, sometimes in both magnitude and direction. For example:
2000: consensus S&P 500 Y/E was 3,318; actual Y/E close was 3,756 (recall that it was a pandemic year)
2021: consensus S&P 500 Y/E was 3,800; actual Y/E close was 4,766
2022: consensus S&P 500 Y/E was 4,825; closing level on Dec 21st was 3,878
Any way you slice it, strategists on the Street missed year-end levels badly in the last three years. This should convince you that trying to predict the level of the S&P 500 at the end of 2023 – or more generally one year out – is a fool’s game. It also reminds us why as investors, we need to be invested in equities for the long-haul (see “Stocks – do they always go up?” in E-MorningCoffee). Having said this and in case you are curious, the Street estimate for the closing level of the S&P 500 at the end of 2023 is 4,008 (+3.4% to closing level of the S&P 500 on Dec 21st). One thing is almost certain – it will not be at that level, and if recent history is an indication, it could be far off one way or the other.
Earnings are easier to predict
Earnings are easier to predict that stock prices, at least in the short term, but this does not mean that stocks prices will follow earnings perfectly. The drivers of earnings tend to be more reliable. Even in cases in which earnings predictions turn out to be correct, stock prices are often different than expected because valuations change for reasons other than just earnings. For example, there are exogenous drivers of stock valuations including sentiment (emotional), technical factors (relative asset class performance / attractiveness) and impossible-to-foresee black swan events. The large number of influential variables makes predicting stock prices in the short-term nearly impossible even for the best strategists.
Glimmers of hope
As of Dec 20th, 2022, the S&P 500 index is down 19.8% YtD, and there are plenty of warning signs on the horizon that might make gains in 2023 look like a real challenge. Before I delve into these concerns, let me provide some glimmers of hope.
There have only been two periods since 1970 that stocks have had negative returns (capital only) in two or more consecutive years: 1973-74 (oil embargo) and 2000-2002 (dot.com bubble)[2]. This might be attributed to the arbitrariness of measuring returns in a calendar year (as opposed to any other period). Nonetheless, I find it particularly interesting to note that even during the double-dip recessions of the late 1970s / early 1980s when US inflation was soaring and monetary policy was ultra-tight, the only year of a negative capital return in stocks was 1981. This period, as brief and as long ago as it might be, could reflect the fact that stocks as an asset class are an effective hedge against inflation, at least vis-à-vis most other asset classes.
The US Dollar has come off its high and is weakening, which should provide tailwinds for earnings of US multinational companies as their products become more competitive on the international stage. A weaker US Dollar also positively affects translation adjustments on non-Dollar earnings (for companies reporting in US Dollars).
The Fed appears to be nearing the terminal level of the Federal Funds rate, assuming inflation continues to slowly decline. The infamous dot plot suggests a terminal Federal Funds rate of 5% - 5.25% (75bps above the current level).
There is a currently downside bias in yields at the intermediate and longer end of the UST curve, although the inflation influences are far from over. Should this downward bias persist, it would lower the cost of borrowing for companies, improving their bottom line profitability. Lower yields also mean that the theoretical discount rate used to discount forward earnings is lower, so that the sum of future discounted cash flows is higher (and the company is thereby more valuable).
Oil prices have been declining, and this means that companies that rely on oil or gas for power, derivative petroleum inputs in production, or transportation, are experiencing improving margins.
If you are an internatioinvestor and are interested in international diversification in your equity portfolio, it is interesting to see how the S&P 500 P/E ratios compare to those of indices in other equity markets including the FTSE 100 (UK), the STOXX 600 (Europe including UK) and the Nikkei 225 (Japan). The table o the below shows how the w the the the he e
However, offsetting these glimmers of hopes are four major concerns, any of which could negatively affect the direction of travel of equity prices in 2023:
State of the global economy, which will affect demand for products and services
Valuation metrics
Technical factors
Potential black swan events
Let me touch on each of these below.
State of the global / local economies The U.K., US and Eurozone are all facing post-pandemic trauma in the form of high inflation that is requiring restrictive monetary policy. This has a ways to run, with the US arguably having the most room to manoeuvre and the U.K. the least. The end result is that all three markets will face slower growth and higher unemployment as inflation slows, and this will have knock-on effects into consumer sentiment and business investment. China, the world’s second largest economy (or third if you consider the Eurozone collectively as a bloc), has a different issue which is how slowly and securely it will emerge from its zero-COVID policies. The world’s growth is very reliant on China, and there is a lot of uncertainty around this country as we head into 2023. These are all macroeconomic issues that create headwinds for companies in the form of higher costs (particularly labour and energy costs), on-going supply-chain disruptions, and potentially demand destruction as consumers pull in their horns. Valuation metrics The metric often used to compare valuations of stocks is the price-earnings – or P/E – ratio. Earnings are only one part of the valuation equation (the denominator), with the multiple applied to these earnings being the other. The graph below has been extracted from a JP Morgan Asset Management report dated Dec 15th 2022 (here), and it implies that the forward P/E ratio (using earnings for the next four quarters and closing S&P 500 level of 3,896) is 16.9x, the average level over the last 25 years.
The forward P/E ratio of 16.9x implies 2023 earnings of the S&P 500 index of $231. For reference, the trailing four quarters’ earnings of the S&P 500 is $222, which means that analysts are expecting earnings growth of 4.1% in 2023. The trailing P/E ratio of the S&P 500 is 17.5x, higher than the forward ratio because the consensus view is that 2023 earnings are expected to increase. However, not all firms agree with the consensus, as you can see from the views of three other firms below.
Yardeni Research expects S&P 500 earnings for 2023 to be $225
Refinitiv expects S&P 500 earnings for 2023 to be $225
JP Morgan Bank (not the asset management arm) is the most bearish of the outlooks I found, projecting a sharp decline in 2023 earnings for the S&P 500 to $205.
Two other things to note regarding earnings are:
Most analysts are projecting a modest decline in this quarter’s earnings (–2% to –2.5% QoQ), which would be the second consecutive decline in MoM quarterly earnings
Looking past 2023, the consensus at the moment seems to be a sharp increase in earnings in 2024 to the $250 to $255 range (because the US is expected to be recovering from a recession which will occur in 2023)
The decline in stock prices this year coupled with the improvement in earnings (albeit slowing) has caused the P/E ratio of the S&P 500 to decline sharply during the course of 2022. According to my calculations, the trailing P/E ratio using the Dec 31st 2021 S&P 500 close (4,766) and earnings for the trailing four quarters at the time (4Q20 to 3Q21, or $198) was 24x. As of Dec 20th 2022, the trailing P/E ratio of the S&P 500 was 17.5x, reflecting a sharp decline in stock prices and a modest uplift in earnings during the course of this year. The decline in the P/E ratio by no means suggests that the index could not fall further, but the significant decline in the P/E ratio this year does mean that the index is less vulnerable on the downside.
If you are an international investor and are interested in international diversification in your equity portfolio, it is interesting to see how the S&P 500 P/E ratios compare to those of indices in other equity markets including the FTSE 100 (UK), the STOXX 600 (Europe including UK) and the Nikkei 225 (Japan). The table to the right shows how the trailing and forward P/E ratios compare across the four markets.
Valuations are also often underpinned by the dividend yield. According to GuruFocus, the dividend yield of the S&P 500 is currently 1.70%, below the historical median (not sure over what period) of 2.35%. The fact that the current dividend yield is lower than the historical median suggests that equities might need to fall further so that the effective dividend yield increases. Also, the highly unconventional monetary policies of central banks over the past decade have created distortions that are slowly starting to right themselves, at least in terms of bond yields. Keep in mind that the dividend yield on stocks was well above the yield on US Treasuries during most of the post- pandemic period. However, this is no longer the case with yields on USTs having risen sharply since early 2022. Lastly, it is logical as far as valuations to also consider the level of interest rates when valuing stocks. Higher interest rates affect stock prices two ways:
Higher interest rates can act as a drag on earnings for companies that rely on the bank or debt capital markets for financing
The level of interest rates has a direct bearing on the value of future cash flows of companies, with a higher discount rate reducing the discounted value of future cash flows (and lower interest rates increasing the value)
Higher interest rates have been a major negative factor influencing US equity prices for much of 2022. In a nutshell, higher interest rates, ceteris paribus, translate into lower valuations. The effect of higher interest rates is of course more pronounced for leveraged companies and for longer duration stocks, meaning those companies that might not be profitable now but are expected to be in the future. This is one reason that the YtD return of the tech-heavy NASDAQ Composite (-32.6%) has been much worse than the return on the S&P 500 (-19.8%). It is important to keep in mind, however, that the level of interest rates can cut both ways as far as valuations, and the effect of lower interest rates will improve valuations, as mentioned in the section “Glimmers of hope”.
Technical factors
There are several technical factors worth considering when looking ahead, including the effect on investor sentiment regarding stocks due to the poor 2022 performance, the desirability of current income, and the performance of credit.
Appetite for stocks generally might have waned as returns have become increasingly negative over the course of this year and the positive effects of pandemic-stimulus have started to fade. Long-duration bonds (like US Treasuries) have performed even more poorly this year, although the outlook currently seem to be more favourable for bonds than for stocks as we move into the new year.
Interest rates were near zero at the beginning of the year because of the Fed’s accommodative monetary policies during the pandemic. On a current return basis, this made stocks – which were offering a higher current return in the form of dividends – more attractive than bonds or bank deposits, an unusual circumstance. However, as the Fed has raised rates over the course of the year in an attempt to normalise monetary policy (and to address persistent inflation), the relative attractiveness of stock dividends has lost ground to bond yields. Bank deposits also look much more attractive as an alternative for investors looking for current returns and have no principal risk.
There is a real risk that macroeconomic factors resulting from restrictive monetary policy could reduce the credit integrity of companies that rely on the capital markets for funding, thereby weakening their balance sheets and reducing their enterprise value. So far, credit has held up nicely. Yields are still not overly burdensome it seems, and many companies – especially high yield issuers – used the unprecedented post-pandemic period of very cheap money to extend maturities, meaning that many do not face imminent risk anyway from having to refinance existing debt.
Longer term macro factors can also be influential and include things like population growth, demographics, productivity and the like.
Black swan events
Black swan events can be defined as events that are not foreseen and – when they do occur – can have catastrophic consequences. You can read a brief description here in Investopedia. Think about market events like the GFC or the dot.com bubble, or indirect market events like 9/11 and – most recently – the pandemic. Currently, the war in Ukraine could go in a direction that might appear low-probability at the moment but could prove very positive or negative for risk assets generally. There’s not much really to say about black swan events, because very few if anyone sees them coming, and their effect on markets and sentiment is often profound. By definition, they are impossible to predict.
Conclusion
Each November and December, every Wall Street firm has its strategists provide views of stock prices at the end of the following year. About the only thing that is certain is that the strategists will be wrong, which is why you need to invest in equities for the long-term. There are too many difficult-to-call variables (other than earnings) that can cause equity prices to fluctuate widely, especially over shorter periods (like one year). The best strategy is to focus on companies with solid earnings growth, and to evaluate the performance of equities over longer periods of time.
_________________
**** Follow E-MorningCoffee on Twitter, and please like and comment on my posts right here on my blog. You need to be a subscriber, so please sign up. Thanks for your support. ****
[1] See article “Top Money Managers See Global Stocks Gaining in 2023” which might only be available for Bloomberg subscribers.
[2] Ibbotson® SBBI® US Large-Cap Stocks (Capital Appreciation Return)
Comments