US Technology leaders support US equity over-performance
The S&P500 Q1 earnings season is almost over, with the pace of announced earnings growth at its lowest since Q3:2009. Specifically, Q1:2020 EPS growth was down by -14% yoy with Consumer Discretionary (-52% yoy), Financials (-44% yoy) and Energy (-28% yoy) leading the decline. On the other hand, Information Technology and Defensive sectors fared better, posting mid-single-digit EPS growth. Looking forward, analyst consensus estimates for Q2/Q3/Q4 EPS growth remain negative resulting in 2020 S&P500 EPS level of $127 or -21% lower compared with 2019 (see graph page 3).
However, equity investors remain focused on how quickly can foregone earnings, due to the lockdown, be recovered. The consensus baseline forecast is for S&P500 EPS to reach $163 in 2021 resulting in +28% annual growth and slightly higher compared with the 2019 level ($162). These expectations broadly assume that economic activity normalizes gradually, whereas social distancing is projected to continue, albeit to a lesser extent, in the second half of 2020 before diminishing further in 2021. However, the degree of uncertainty vis-a-vis the EPS outlook remains elevated compared with the historical norm. Note that the total number of S&P500 companies issuing EPS guidance year-to-date for Q2:2020 (35) is well below the five-year average for a given quarter of 107 companies. Key factors that make EPS predictions more challenging than usual are: i) the pace of economic re-opening relative to second wave COVID-19 infections; ii) the possibility of a medical breakthrough (new therapies, testing, vaccine); ii) the impact of a double-digit unemployment rate on consumer spending (70% of US GDP — see Economics) and/or a long-lasting effect on the economy (elevated business and household insolvencies).
With the S&P500 up by 28% since its mid-March lows (-2% wow & -11% YtD), equity prices appear very expensive focusing on traditional metrics such as the next 12-month forward P/E ratios. The S&P500 hovers at 21x or 2.8x STDEV above its 15-year average. However, in view of the policy-induced nature of the 2020 earnings collapse (lockdown) and expectations for a gradual return to normalcy, one should check FY2 forward P/E ratios. Based on data from Factset, the S&P500 FY2 P/E ratio at 17x still remains above its 15-year average, albeit at less extreme levels of 1.8x STDEV (see graph below). On the other side of the Atlantic, the Eurostoxx is trading at 17x or 2.1x STDEV above its 15-year average (12-mth forward P/E) and at 13x or 0.8x STDEV above its 15-year average (24-mth forward P/E).
The S&P500 carries large earnings and market capitalization weights in the relatively “immune” sectors of the economy. Indeed, IT (MSFT, APPLE) and Communication Services (Google, FB) account for circa 10% of S&P500 2019 Earnings before Taxes and 17% of S&P500 Market capitalization of $25 trillion (as of May 15, 2020). Alongside Amazon (AMZN / Consumer Discretionary), these five companies or FAAMG account for circa 22% of the S&P500 market capitalization, marking the highest concentration ratio since 1985 and are up by +11% YtD (equal-weighted) vs -17% YtD for the S&P500 excluding FAAMGs (see graph below). This high-valuation basket (FAAMGs) relies on healthy fundamentals (steady stream of revenues and low debt albeit with higher Covid-19 related expenses — see Amazon) suggesting that “catching-down” (sharp price decline) with low-valuation sectors (Energy: -35% YtD, Autos: -40% YtD, Banks: -25% YtD) appears less likely, assuming that economic activity normalizes in the course of the year. Buying US (Technology) leaders could continue to offer value.