- Valuations are stretched, leaving little room for risk. S&P 500 Index is trading at (i) a 28% premium to its historical average and (ii) at larger-than-average premiums relative to other DMs. Risks for a valuation contraction has risen and earnings disappointment could be a likely trigger.
- While earnings have rebounded significantly this year (51% YoY), growth has likely peaked and should normalise moving ahead. The broad-based EPS recovery should fade, leaving Consumer Discretionary and Industrials sectors as the likely earnings drivers next year.
- US companies are facing mounting cost pressures from higher wages and material costs. While this has yet to materially affect profitability, we expect more pressure on margins in the coming quarters.
- Earnings revision momentum is running out of steam. Positive earnings revisions for S&P 500’s top five largest sectors (by earnings contribution), have started to flatten in the last quarter. Big Tech is increasingly at risk of earnings disappointment which can pose a risk to aggregate US equities performance.
- Elevated valuations should limit upside potential. We project a target price of 4940 for S&P500 index by end-2023 which implies a 5% upside potential. US equities are increasingly less attractive and we maintain a 2.5 Stars “Neutral” rating for the region.
2021 has been remarkable for US equities. The combination of an easy monetary backdrop, robust economic recovery, and strong earnings growth has extended US equities’ performance (as gauged by the S&P 500 index). S&P 500 is now up by almost 25% in the year-to-date (as of 7 Dec, in local currency terms)) and is one of the top-performing equity markets globally. That said, we believe 2022 may prove to be challenging for US equities as uncertainties and risks re-surface. In our outlook, we assess potential risks, drivers and the upside potential for US equities.
Chart 1: S&P500 Index has performed fairly well in 2021
Valuations are stretched, leaving little room for risks
Despite strong earnings tailwinds and firm economic growth, we believe these positives have been baked into valuations. S&P 500 index is now trading at a forward P/E Ratio of 22.3X FY2021 EPS (Chart 2), above the 10-year historical average of 17.4X and our designated fair P/E ratio of 20.0X. Valuations are currently at an extreme (z-score of 1.3) and represent a 28% premium over the 10-year average.
To justify these valuations, earnings for US equities need to catch up. Unfortunately, consensus earnings growth forecast for 2022 currently stands at 8%, which is only slightly above half of the required growth rate for valuations to be justified (based on our designated fair P/E ratio of 20X).
US equities are also expensive across other key valuation metrics such as P/B ratio, EV to EBITDA and free cash flow yield (Table 1). Most of these metrics have a z-score between 1 to 3, on both a 10 and 20-year basis. In other words, US equities are currently trading between +1 to +3 SDEV across these key valuation metrics.
On a relative basis, US equities are also trading at a significant premium to their DM counterparts. Against European equities, they are trading at a 37% premium as compared to a historical average of 20%. Against Japanese equities, they are also trading at a 25% premium as compared to a historical average of 9%.
Chart 2: Forward P/E ratio trading at more than +1 SDEV above historical average despite rising earnings
Table 1: Valuations are frothy across key metrics as well
|
Valuation Metrics |
Current |
Z- Score |
|
|
10-year |
20-year |
||
|
Forward PE ratio (FY) |
21.9 |
1.3 |
1.7 |
|
Forward PE ratio (FY +1) |
20.4 |
1.9 |
2.3 |
|
PB ratio |
4.7 |
2.6 |
3.1 |
|
EV to Sales |
3.4 |
2.1 |
2.3 |
|
EV to EBITDA |
16.4 |
1.5 |
2.1 |
|
Free Cash Flow Yield |
3.5 |
1.5 |
1.0 |
|
Source: Bloomberg Finance L.P., iFAST estimates, iFAST compilation. Data as of 7 Dec 2021. |
|||
Heightened risk of valuation contraction
Considering both absolute and relative valuations, we deem US equities to be overvalued. There is little room for risks with many positives backed into equity valuations. We expect mounting risks for a valuation contraction (market pullback).
As suggested in our previous update, we opined that one of the likely triggers for de-rating could be earnings disappointment. Should earnings fail to materialise in line with optimistic market expectations and begin to moderate lower, we believe US equities may re-price lower. This is becoming an increasingly likely outcome since our previous update and we are wary of it for the following reasons.
Earnings expected to normalize next year
Earnings for US equities have rebounded significantly and are estimated to grow 51% YoY in ’21 (as of 7 Dec), fueled by a mixture of a cyclical EPS rebound, and strong profitability from internet companies. However, earnings growth has likely peaked this year and we expect it to normalise moving ahead, moderating to 8% and 10% for ’22 and ’23 respectively (as of 7 Dec).
The Consumer Discretionary and Industrials sectors are likely the only ones supporting earnings growth next year. This is in contrast to the broad-based EPS rebound driven by both cyclical and growth sectors seen this year. Based on earnings estimates, the biggest earnings drivers - IT, Health Care and Financials sector (collectively contributing almost 60% of index EPS) - are expected to see a moderation in earnings growth (Table 2).
- IT – Fading post-Covid consumer demand and earnings headwinds from mounting costs, supply bottlenecks and tax reform.
- Many IT companies have low effective taxes and a high share of international revenue, making them susceptible to a potential minimum tax and foreign income tax hike, which may be implemented as early as late ‘22.
- Consumer demand for IT goods and services, while still robust, is expected to normalise in a post-Covid environment.
- Cost issues and supply chain bottlenecks will further also weigh on earnings for globalised IT companies as highlighted by industry leaders like Apple and Microsoft.
- Healthcare – Normalisation of earnings as government, business and consumer Covid-spending moderates.
- Major normalisation of earnings as the Covid situation improves globally. Spending by governments, businesses and consumers is projected to fall.
- Potential healthcare reform such as the regulation of drug prices should curtail the sector’s profitability but high pricing power may keep earnings buffered (EPS likely to come in below long-term trend but stay positive).
- Financials – Large reserve releases, which boosted earnings this year, will fade but we expect an earnings rebound in ’23.
- Large reserve releases this year have dramatically boosted bank earnings, resulting in high-base effects, which explain the negative ‘22 EPS growth forecast.
- Expect an EPS rebound in ’23 due to the combination of low-base effects and increasingly higher interest rates. The latter, in particular, should uplift banks’ earnings, which has high sensitivity to rising rates.
Table 2: Strong EPS rebound, driven by cyclical and growth sectors this year, is expected to fade in 2022
|
Sectors |
Weight |
Earnings Growth (YoY) |
|||
|
2020 |
2021 |
2022 |
2023 |
||
|
IT |
26.9% |
12% |
35% |
9% |
11% |
|
Comm. Services |
15.0% |
-7% |
48% |
7% |
14% |
|
Cons. Disc. |
12.9% |
-37% |
69% |
23% |
19% |
|
Health Care |
11.8% |
8% |
21% |
4% |
3% |
|
Financials |
10.5% |
-26% |
82% |
-11% |
11% |
|
Industrials |
7.5% |
-50% |
81% |
36% |
16% |
|
Cons. Staples |
6.0% |
4% |
11% |
7% |
8% |
|
Energy |
2.5% |
-109% |
N.M. |
30% |
-6% |
|
Real Estate |
2.5% |
-30% |
47% |
-6% |
11% |
|
Materials |
2.3% |
-9% |
94% |
3% |
-3% |
|
Utilities |
2.2% |
8% |
-1% |
5% |
7% |
|
S&P 500 |
|
-16% |
51% |
8% |
10% |
|
Source: Bloomberg Finance L.P., iFAST estimates, iFAST compilation. Data as of 7 Dec 2021. |
|||||
US companies are facing rising cost pressures
Aside from the normalisation in earnings growth for the S&P 500 index, headwinds to earnings are also quickly materialising. According to the National Association for Business Economics (NABE) Business Conditions survey (Chart 3), the number of companies reporting higher wages and material costs are near historical peak levels, a clear indication of mounting cost pressures.
Furthermore, both the cost-of-goods-sold (COGS) and operating expenses (OPEX) to sales ratio for the S&P 500 Index are near historical lows, and are flattening (Chart 4). We are watching for COGS to sales ratio - a major cost indicator - to turn higher as it tends to lead its OPEX counterpart and may suggest rising cost pressure. With soft economic data reinforcing - and, in our view, also leading - index level data, we expect higher cost pressures on S&P 500 companies in the coming months which will eventually weigh on margins.
Chart 3: Number of companies reporting higher costs are near peak levels
Chart 4: Costs for companies are expected to pick up next year, pressuring margins
Earnings revision momentum running out of steam
S&P 500 Index’s positive earnings revision momentum, which has been strong since the start of 2022 is seemingly running out of steam. The index’s earnings and sales beat (the amount which earnings and sales beat estimates), while still positive, have declined at a larger magnitude in 3Q ’22.
In 1Q ’22, US companies beat earnings estimates by almost 22% but this number has fallen to 14% in 2Q and subsequently 9% in 3Q. While positive surprises are still relatively strong this quarter compared to the long-term average, it is clear that this value has declined notably and is normalising quickly.
On a sectoral level, positive earnings revisions for S&P 500’s top five largest sectors (by earnings contribution), have started to flatten in the last quarter (Chart 5). An increasing number of companies, in particular market leaders, within these sectors are seeing a moderation of earnings and sales beats. Collectively, these five sectors contribute around 75% of S&P 500 Index earnings, making a slowdown in positive revisions (or even negative revisions) a potential drag to index earnings growth.
Moving ahead, with earnings headwinds mounting, we expect a continued flattening in S&P 500 Index’s positive earnings revision, with some sectors potentially facing negative revisions. Moreover, history has shown that the S&P 500 Index tends to face negative earnings revision post-crisis, as consensus was often overly-optimistic. We may see this dynamic play out in the later part of 2022, which would further reinforce our view.
Chart 5: After strong positive revisions for much of 2021, earnings estimates are flattening out for major sectors
Earnings disappointments are surfacing across big tech names
We note that Big Tech (FAAMG - Apple, Microsoft, Amazon, Alphabet and Meta Platforms) might be increasingly at risk of earnings disappointments given earnings normalisations and mounting earnings headwinds. This can pose a risk to aggregate US equities performance, given Big Tech’s collective outsized weight of 23% in the S&P 500 index.
Apple and Meta both saw revenue misses in 3Q (Table 3) and commented on an increasingly challenging outlook. The former sees ongoing supply constraints, in particular silicon shortages and Covid-related manufacturing disruptions, while the latter expects headwinds from Apple’s iOS 14 changes, as well as macroeconomic and Covid-related factors. Amazon too had a disappointing quarter where it delivered a big earnings miss (Table 3). Despite the coming holiday season, the company foresees challenges such as heightened costs in its Consumer business as a result of labour supply shortages, rising wage costs, supply constraints, and increased freight and shipping costs.
More broadly, on a sectoral level, S&P 500’s IT, Consumer Discretionary and Communications Services sectors are all showing progressive declines in quarterly earnings surprises (Chart 6). This suggests that the trend of super-normal earnings results (relative to estimates) for these sectors might be coming to an end.
Table 3: Some of the Big Tech names are starting to see revenue and earnings miss in recent quarters
|
Big Tech |
Weight |
Revenue Surprise |
Earnings Surprise |
Earnings Growth |
|||||
|
3Q |
2Q |
3Q |
2Q |
2020 |
2021 |
2022 |
2023 |
||
|
Apple |
6.3% |
-1% |
10% |
0% |
28% |
10% |
71% |
2% |
7% |
|
Microsoft |
5.7% |
3% |
4% |
10% |
13% |
21% |
38% |
17% |
12% |
|
Amazon |
4.0% |
-1% |
-2% |
-32% |
23% |
82% |
-2% |
28% |
47% |
|
Alphabet |
4.4% |
2% |
11% |
11% |
27% |
17% |
100% |
4% |
15% |
|
Meta Platforms |
2.0% |
-2% |
4% |
1% |
20% |
14% |
43% |
2% |
19% |
|
Source: Bloomberg Finance L.P., iFAST estimates, iFAST compilation. Data as of 7 Dec 2021. |
|||||||||
Chart 6: IT, Consumer Discretionary and Communications Services sectors are facing a decline in quarterly earnings surprise
Rising interest rates likely to challenge valuations
Valuations of US equities may also face further challenges next year in terms of rising policy rates. History shows that whenever Fed Fund rates are raised, valuations are pressured in return (Chart 7). By examining prior rate hike cycles, we note that valuations have either fallen or at best levelled when the Fed raises policy rates. In addition, we observed that (i) the stronger the pace of rate hikes (i.e. higher rates in a shorter time); or (ii) the expectation of (i), tends to result in a larger valuation contraction.
With US equities comprising a large share of high-growth stocks, which tend to possess longer equity durations, we expect valuations to be relatively more sensitive to interest rate changes. Based on consensus expectations that the rate hike cycle will begin next year, further valuation expansion for US equities may be increasingly challenging, and de-rating risks will climb while approaching a potential rate hike.
Chart 7: Valuations have either fallen or at best levelled when the Fed raises policy rates
Limited upside potential for US equities
Current frothy valuation levels should limit upside potential moving ahead. Applying our designated fair P/E ratio of 20.0X on EPS projections for the next two years, we project a target price of 4940 for the S&P 500 Index by end-2023. This implies a 5% upside potential over the next 2 years (based on 7 Dec 2021 closing price) which we view as relatively unattractive.
In addition, we see little room for earnings to go wrong (If valuations remain around current level), before a reduction in S&P 500 Index’s upside potential. Based on our estimates, (i) a 5.1% negative EPS revision for both ‘22 and ’23; or (ii) a fall in EPS growth to an average of 6% for ‘22 and ’23, should result in a negative return for the S&P 500 Index by end-2023.
In totality, US equities are increasingly less attractive and we maintain a 2.5 Stars “Neutral” rating for the region. As we head into 2022, we recommend investors to underweight US equities and remain cautious when it comes to sector and stock selection.
Chart 8: S&P 500 index price and forecasted EPS
Table 4: Projections and potential upside for S&P 500 Index
| US (S&P 500 Index) | FY2020 | FY2021 | FY2022 | FY2023 |
| PE ratio (X) | 27.2 | 22.4 | 20.8 | 19.0 |
| Projected earnings growth (YoY %) | -16% | 51% | 8% | 10% |
| Projected Earnings Per Share (EPS) | 138 | 209 | 225 | 247 |
| Target fair price (Based on 20.0X Fair PE ratio) | - | - | - | 4,940 |
| Potential upside (%) | - | - | - | 5.3% |
| Source: Bloomberg Finance L.P., iFAST estimates. Data as of 7 Dec 2021. | ||||
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