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US markets in 2022: Will the S&P 500 continue to rally?

Current frothy valuation levels should limit upside potential

December 20, 2021 / 11:31 AM IST

US equities have performed very well in 2021 on the back of an easy monetary backdrop, robust economic recovery, and strong earnings growth. The S&P 500 is now up almost 25 percent year-to-date (as of  Dec 7) 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, and why we are increasingly cautious about this market.

Valuations stretched, little room for risks

Despite strong earnings tailwinds and firm economic growth, we believe these positives have now been baked into valuations. S&P 500 index is trading at a forward P/E Ratio of 22.3X FY2021 EPS (Chart 1), above its 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 percent premium over the 10-year average.

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 percent premium as compared to a historical average of 20 percent. Against Japanese equities, they are also trading at a 25 percent premium as compared to a historical average of 9 percent.

Heightened risk of valuation contraction

Considering both absolute and relative valuations, we deem US equities to be overvalued. We opine 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.

Earnings expected to normalise next year

Earnings for US equities have rebounded significantly and are estimated to grow 51 percent YoY in ’21 (as of 7 Dec), fuelled by a mix 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 percent and 10 percent for ’22 and ’23 respectively (as of 7 Dec).

The Consumer Discretionary and Industrials sectors will likely be the only ones supporting earnings growth next year.

-IT: Fading post-Covid consumer demand and earnings headwinds from mounting costs, supply bottlenecks and tax form.

-Healthcare: Normalisation of earnings as government, business and consumer Covid-spending moderates.

-Financials: Large reserve releases, which boosted earnings this year, will fade but we expect an earnings rebound in ’23.

US companies facing rising cost pressures

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 running out of steam

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. 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.

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 percent in the S&P 500 index.

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. 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 a strong pace of rate hikes, or even the expectation of it, 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.

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 which implies a 5 percent upside potential (based on Dec 7, 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 percent negative EPS revision for both ‘22 and ’23; or (ii) a fall in EPS growth to an average of 6 percent for ‘22 and ’23, should result in a negative return for the S&P 500 Index by end-2023.

In conclusion, US equities are increasingly less attractive and we maintain a 2.5 Stars ‘Neutral’ rating for the region.
Colin Low is Assistant Manager, Macro Research, Singapore
first published: Dec 20, 2021 11:31 am