To put these numbers into perspective, analysts now expect S&P 500 earnings for the year to come in at 80% above the level that was expected at the outset of the crisis year of 2008. In Europe, where expectations have risen at the same rate so far this year, profits are still on course to be 20% lower than had been expected for 2008 (the numbers here use the MSCI indexes). The global financial crisis, although perceived to have its roots in the U.S., has done far greater damage to corporate Europe than to corporate America:
On both sides of the Atlantic, the single biggest question for companies could concern margins. A central issue for European companies since the crisis has been their lack of profitability. Even when the continent’s stricken banking system is excluded, they have found it very difficult to build margins, as this chart from Morgan Stanley shows. The expectation is for a significant improvement this year, and much depends on whether this happens:
In the U.S., where companies have found it much easier to jack up profitability, margins have already completed their recovery from Covid, and the current expectation is that they will fall slightly for the first quarter, from the final three months of last year. That would reflect increasing pricing pressures, and an inability to pass on costs—in other words, rising costs might manifest themselves in lower profits for companies, rather than higher prices for consumers. The effect is only expected to be small, but the issue of margins and pricing power will be at the top of the agenda:
Margins in the U.S. might yet, in other words, reveal whether there really is overheating in the economy, and whether it will manifest itself in inflation, or in pain for the corporate sector. And that is arguably the single most important issue in global finance these days.
What It’s Worth
Tobin’s Q, the ratio of total stock market capitalization to the total replacement value of the assets in its companies, is at an all-time high, as shown by this chart from Morgan Stanley. Over time it tends to be mean-reverting. It is a long way from the mean now:
The immediate riposte is of course that the bond market is also historically expensive. Taking into account how low bond yields are, stocks don’t look so expensive. This has been a respectable argument for almost all of the post-crisis decade, and explains why the stock market has done so well. Bonds looked very expensive compared to stocks at the worst of last year’s Covid shutdown, and sent a great signal to buy equities. But after the past year’s titanic stocks rally, and a sharp rise in bond yields over the last few months, the argument that they make equities look cheap appears out of date.
The charts below are from Mike Wilson, chief U.S. equity strategist at Morgan Stanley. Using a conventional equity risk premium, which involves subtracting the 10-year Treasury yield from the earnings yield (the inverse of the price-earnings multiple) for the S&P 500, we find that stocks are bang in line with their most expensive level since 2002. It’s made sense to buy stocks for most of that period, of course, but valuation isn’t terribly exciting.
Perhaps it’s time to return to the tale of valuations. Short-term yardsticks based on profits are obviously thrown out by such huge earnings volatility, but there are still ways to get a handle on valuations. None of them offers much comfort.