EQUITIES COMMENT - 2021 - The Year of Earnings; 2022 - Year of P/E Multiple?
2021 - Year of Earnings The gains in North American stocks during 2021 were driven by surging corporate profits. Earnings for the TSX are estimated to have more than doubled from 2020 while S&P 500 earnings increased over 50%.Both the TSX and S&P 500 made new all-time high’s during the fourth quarter due to continued very strong earnings growth. The emergence of Omicron initially caused a modest selloff in stocks however, as data showed hospitalizations were much lower than with previous variants, markets resumed their climb. During the fourth quarter, the TSX gained 6.5% while the S&P 500 was up 10.7% in Canadian dollars. For the year, the TSX had a return of 25.1% and the S&P 500 27.6%.
Earnings Influenced Sector Performance Among TSX sectors, Real Estate was the second best performer and it is expected to have the strongest earnings growth in 2021. For the S&P 500, Energy will have the strongest earnings growth and it was indeed the top performing sector. In terms of underperforming sectors, TSX Materials is predicted to have the worst earnings growth and it had the second worst return for the year. Utilities had the lowest earnings growth among the S&P 500 sectors and the worst return.
Positive Earnings Outlook in 2022 Omicron has so far not derailed the earnings picture for 2022. Economic growth is expected to remain strong. The solid financial position of consumers in the United States, the largest economy in the world, will support spending. Low inventories of goods will keep manufacturing activity at a high level. Buoyant economic growth will benefit corporate profits. Earnings are forecast to rise about 8% for the TSX and 12% for the S&P 500 this year.
2022 – Year of the P/E Multiple? Despite much higher stock prices, price to earnings multiples (the ratio of a stock price or index value to earnings), a standard valuation measure, came down in 2021 due to the massive increase in earnings. Our research indicates p/e multiples are generally not expensive (historically high) outside of the Technology sector.
Low rates mean higher p/e multiples One of the key factors supporting p/e ratios has been low interest rates. It now seems very likely central banks will raise interest rates this year due to declining unemployment and higher inflation. Rising interest rates could put downward pressure on p/e’s, particularly for stocks with high multiples. What this means is the “p” (price) could fall. The S&P 500 index has a greater exposure to high p/e multiple stocks than the TSX Composite so we see more risk of multiple compression for U.S. stocks.
Risks to 2022 Outlook Rising interest rates could eventually have a negative impact on economic activity however, we do not expect rates to reach such a level this year. Policymakers want to ensure that unemployment will remain low so we expect a gradual reduction in stimulus.
Central banks have recognized that higher inflation could persist for longer than originally expected however, it is expected to wane as we move through the year. Should inflation prove to be more entrenched, central bankers might have to raise interest rates more quickly.
The global economy is still being held back by the pandemic. Increased vaccinations among younger children and in the developing world will allow greater movement of people and improved economic activity. While we are experiencing a more rapid spread of COVID with the appearance of Omicron, the advent of a more lethal or vaccine resistant variant would have a negative impact on economic growth, to say nothing of the health effects for people.
So far, the world economy is managing to withstand significantly higher energy prices. Typically, increased oil prices act like a tax and reduce economic growth. The impact may not show up for a while due to effects of the pandemic however, a further rise in energy prices would likely dampen growth.
Despite the above mentioned risks, we expect stocks to deliver returns including dividends of 5%-10% in 2022. In Canada, the dividend yield on stocks remains attractive compared to the ten year Canada bond yield. We expect dividends to increase significantly in 2022 as companies increase payouts from their earnings windfalls. Our targets are 22,750 for the TSX and 4,900 for the S&P 500. These are conservative and reflect our view that p/e multiples will be stable (TSX) or decline (S&P 500). Should interest rates rise less than expected or earnings be stronger, our targets could be too low.