(Bloomberg Intelligence) — Policy accommodation and slow economic recovery could result in the S&P 500 stretching to new highs within the next 12 months, in our view, contrary to analysts’ forecasts for the index to hold below former peaks. Earnings are key: Our model says 2.7% growth, analysts 1.6% and the market is pricing in a further 4.1% drop.
Unsteady prospects surrounding recovery and the 2020 election may weigh on risk tolerance and keep stocks consolidating spring gains in the near term, but our macro-derived model for the S&P 500 suggests Federal Reserve support will likely be enough to keep valuations elevated as stocks find their earnings footing. Our base-case scenario — which assumes short-term interest rates remain extremely low, the yield curve widens slightly to 66 bps, credit spreads stay wide and EPS inches higher — suggests stocks are fairly valued at 21.2x earnings. Meanwhile, earnings growth of 2.7% seems achievable as long as the economy keeps healing.
Our assumptions for macroeconomic recovery are extremely conservative, with limited recovery in employment conditions, durable-goods orders and commodity prices over the next 12 months.
S&P 500 gains may be a bit above those implied by the aggregated bottom-up consensus, according to our baseline scenario, and stocks could surpass former peaks if economic progress beats low expectations. Analysts forecast less than a 2% recovery in EPS over the next year, and a multiple of 22x for the index, landing at an aggregated S&P 500 target of 3,361. Our model assumes a very modest recovery about half as strong as average in the first year after recession, or 2.7% EPS growth off the likely 2Q low.
If the recession is extended and earnings tumble another 10%, stocks could sink to 2,590. However, if EPS growth matches the long-term average of 10% in the first year of recovery, stocks could close in on 3,613.
The historical scope of EPS downturns and recoveries has been quite wide, but the average one-year rebound following EPS lows is 10%. An analysis of the troughs in EPS levels since 1959 reveals that in the year leading into the low point, EPS contracted by a median 14.6%; it stretched from no decline in 1998 to the 35.8% drop in the Great Financial Crisis. Recoveries were similarly varied, posting a median 10.1% EPS expansion, but varying from 0.8% associated with the 1970 earnings recession to a 26.5% gain following one in 1975.
The Covid-19-fueled earnings recession will likely be unique: Bigger declines usually are followed by larger recoveries, but that’s not expected this time. Analysts forecast 1.6% EPS growth over the next 12 months; our model implies 2.7%.
Extremely accommodative monetary policy and its effect on interest rates and credit spreads should effectively elevate valuations, keeping equity prices from testing lows, even if economic progress is extremely lumpy. If our valuation model is correct — and very low interest rates but improving prospects for a modest recovery imply a fair multiple for S&P 500 stocks is almost 21.2x — then current market prices suggest the expectation that earnings will fall by almost an additional 4.1% in the 12 months ahead.
This seems unlikely as long as economic progress builds slowly over the next few months, but it’s certainly not beyond the realm of possibility if reopenings can’t be sustained.