Shep Perkins, CFA
Chief Investment Officer, Equities
Despite the elongated pandemic and fears about inflation, we believe the bull market remains intact thanks to strong earnings growth coupled with higher-than-expected price/earnings (P/E) multiples.
Before the pandemic, the S&P 500 Index eclipsed 3,000, and we observed that a path was paved for it to reach 5,000 in 3–5 years. Last January, we described the pandemic as a “springboard” for many stocks and believed the index could reach that milestone even sooner. Where does our projection stand now?
Today, the S&P 500 is already within 10% of that 5,000 target. So is it overvalued? Or time for a pause or retreat? For sure, new variables pose a threat to advancing equities, such as inflation, the Federal Reserve taper, and another Covid-19 variant.
Yet, a foundation for strong performance — corporate earnings growth and low nominal interest rates — remains solid. This, we believe, will power the S&P 500 past 6,000 by 2024.
Inflation and Omicron: Critical variables
Inflation sustained above 4% has been a clear drag on equity indexes. Recent monthly inflation prints above 6% and the Fed’s growing hawkishness stoke concerns. Persistent high inflation that spurs a rise in long-term interest rates would put downward pressure on P/E multiples.
It remains to be seen how the COVID variant Omicron will impact trends, especially inflation. On the one hand, it can be seen as an antidote for inflation. It dulls the edge of the sharp economic rebound we’ve experienced globally and should help mitigate the pressure of upward prices as supply chain bottlenecks and other logistic challenges start to ease.
On the other, the Omicron wave is fouling manufacturing activity, especially in China, which could prolong shortages. Ultimately, this variant could mark the beginning of the end of the global pandemic, bolstering economic activity further and extending inflationary trends.
Either way, some commodity prices will likely retreat, as we’ve already seen with chemicals. Moreover, the labor supply crunch might see relief as businesses adjust to the Omicron wave and implement labor-saving productivity measures.
Going forward, we see the current inflation spike retreating in the second half to 2% to 4% — still a bit higher than in most of the past two decades, but comfortably below the current spike, which should please equity markets.
A very different S&P today
Another powerful force for equity valuations and performance is the index’s composition, which has changed meaningfully over recent decades.
For example, in the 1970s, capital-intensive, cyclical companies in industries such as energy, materials, and industrials made up a significant portion of the index.
Today, much more of the S&P consists of higher-margin and capital-light businesses with higher growth rate potential. These tend to be resilient in times of economic turbulence and are in sectors such as technology, communications, and health care, where higher P/E multiples are warranted.
The changing composition of the S&P 500
Higher-margin, capital-light businesses make up more of the index today
Source: Putnam research. The chart shows the change in the combined weighting of each group over 10-year periods. Real Estate is included within Financials.
Equities are powered by earnings growth
Despite inflation fears and Covid impacts, earnings growth was a key driver of equity market performance in 2021. Businesses are operating more efficiently, revenue growth is resilient, and margins are expanding. We believe earnings will continue to be a significant driving force for equity returns in 2022.
According to S&P Dow Jones Indices, S&P 500 earnings per share were $157 in 2019. In a big surprise, despite pandemic-induced economic disruptions, EPS rose to an estimated $202 for 2021 — that’s 30% over the preceding two years. We believe a strong earnings growth trajectory is likely to continue as the economy rebounds through 2024.
For example, if we see annual earnings growth of 10% per year (slower than recently), we expect about $270 per share of S&P 500 earnings in 2024. Applying a P/E multiple of 22.5x — which we believe is warranted given low interest rates and the index’s higher-quality composition — would bring the S&P 500 past 6,000 by 2024. This is more than 25% higher than its current level.
S&P potential for 2024
Source: Putnam research.
For illustrative purposes only. This data is not intended to forecast or predict future events and is not intended to be projections of performance. Like the output of any model, this analysis may be subject to limitations, is not guaranteed, and may produce results that diverge from any past or future results.
The views and opinions expressed are those of the authors, are subject to change with market conditions, and are not meant as investment advice.
Our investment techniques, analyses, and judgments may not produce the outcome we intend. The investments we select for the fund may not perform as well as other securities that we do not select for the fund. We, or the fund’s other service providers, may experience disruptions or operating errors that could have a negative effect on the fund. You can lose money by investing in the fund.
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