James Ragan, CFA, Director of Wealth Management Research
Following Russia’s military invasion of Ukraine, we are reminded of the immeasurable destruction and death suffered in wartime and our hearts go out to the Ukrainian people. Following news of the attack overnight, global equities traded sharply lower on Thursday, and U.S. equities followed suit, with the widely followed large-cap S&P 500 dropping 2.6% in early trading. By the end of trading on Thursday, 2/24/22, U.S. equity markets rallied and closed higher for the day, including the S&P 500, which gained 1.5%. Investors and markets were anticipating military action over the past week following the aggressive build-up of Russian forces on the Ukrainian border. From 2/16/22 to 2/23/22 (just four trading days), the S&P 500 dropped 5.6% and the Nasdaq Composite (often used to reflect large-cap growth stocks) declined 7.7%. As of the close of trading on 2/24/22, the S&P 500 and Nasdaq Composite indices were down 10.0% and 13.9%, respectively, in 2022 year-to-date and the decrease from the most recent all-time high closing prices was even greater for both.
For investors, the potential disruption to the global energy (oil and gas) and commodities markets is likely to keep prices high, or even drive them higher (including oil, aluminum, and wheat, among others), at a time that inflationary concerns are already elevated, likely prompting the U.S. Federal Reserve Bank (Fed) to soon begin raising short-term interest rates and remove monetary accommodation from the financial system. In recent weeks, U.S. economic activity appears to be lifting from a COVID-19 omicron slowdown, making it easier for the Fed to raise interest rates (rate increases are more problematic when growth is weak). One investor fear is that sanctions on Russia from the West could slow the global GDP recovery while also stoking inflation, putting the Fed in a tough position to combat inflationary pressures. For now, uncertainty rules as the outcome of the Russian invasion is impossible to predict. At one extreme, Russia could pull back forces after receiving concessions; at the other, President Putin could push to overthrow the Ukrainian government, creating a refugee crisis, or even move beyond Ukraine. We also believe the Chinese government is closely watching the international response to the Russia expansion given their own interests in retaking territory viewed as rightfully theirs. Combined, this is likely to weigh on investor sentiment over the near term, in our view, and could create ongoing market volatility and weakness. But we also argue that investors should stay the course and use market weakness to upgrade portfolio quality, add exposure to market-leading companies, and improve sector and style (value and growth, cyclical and defensive) diversification.
We make no changes to our S&P 500 fair value estimate of 4,900, which represents 21.5x the 2022 S&P 500 FactSet consensus earnings estimate of $223.36 per share, and 19.9x the estimate for 2023 of $246.38 per share (on a price-to-earnings, or P/E basis). Based upon the S&P 500 price level of 4,766 at year-end 2021, this represented a potential 2022 price gain of just 2.8%, but after the market decline to start the year, the fair value estimate is 14.2% above the S&P 500 closing value on 2/24/22. We believe that GDP and earnings growth trends will begin to normalize at lower levels in 2023 and beyond, creating more modest upside potential for equity gains. We also see above-trend conditions in 2022. Below are a few factors that we believe create a solid outlook for U.S. equities as 2022 moves forward:
- Valuations appear attractive. The S&P 500 valuation on a P/E basis has dropped considerably since the start of 2022. As of 2/24/22, the index traded at 19.2x the 2022 FactSet consensus earnings estimate (referenced above); this is compared to 21.5x the estimate at the beginning of 2022. The current S&P 500 P/E on 2023 estimated earnings as of 2/24/22 was 17.4x. In our view, further market weakness will see buying support from investors attracted to favorable valuations.
- Both GDP and earnings growth expectations remain above pre-pandemic trends. Over the six years from 2014 to 2019, U.S. real GDP growth averaged 2.4% annually. Following a 3.4% recession decline in 2020, growth rebounded to 5.7% in 2021. The FactSet consensus estimates for GDP growth in 2022 and 2023 are 3.8% and 2.4%, respectively. This suggests above-trend growth in 2022, and still on trend next year. This provides an environment for well-managed companies to report solid results. S&P 500 earnings growth from the same six-year period (2014-2019) averaged 6.6%. The pandemic disrupted the trend as S&P 500 earnings decreased 14.1% in 2020, only to rebound 50.1% in 2021. The FactSet consensus S&P 500 earnings estimates for 2022 and 2023 (as of 2/24/22) are 8.5% and 10.3%, respectively. In our view, the expectation for above-trend S&P 500 earnings growth is positive for U.S. equities. We do not believe that Russian sanctions will materially impact earnings growth for U.S. companies.
- U.S. daily consumer activity has accelerated in February. While consumers appeared to pull back on activities and spending in late December and January as Omicron cases were peaking, the data in February has reversed to the positive. According to the Transportation Security Administration (TSA), the 7-day average of airline passengers through TSA checkpoints averaged 1.98 million (M) over the seven days ended 2/23/22. This was an increase of 41% just since 1/31/22 (daily average was 1.40M), and excluding last year’s Thanksgiving and Christmas periods, was the highest level since August 2021. In addition, according to STR, U.S. hotel occupancy increased to 59.1% the week ended 2/19/22, up from 45.4% in early January, and revenue per available room increased 52% over that same period. The emerging trends in February suggest to us that Omicron headwinds are fading, and support our view that economic momentum at the end of the first quarter will support solid growth expectations for the second quarter and beyond.
- Recent economic data has exceeded expectations. Starting with January’s employment report, which reflected an increase of 467 thousand net new nonfarm payrolls (reported by the Bureau of Labor Statistics on 2/4/22) and exceeded expectations, many key economic releases from the Federal Government and private surveys point to a strong U.S. economy. In the past two weeks, retail sales, industrial production, purchasing managers’ surveys (PMIs) for manufacturing and services, and personal consumption expenditures (spending) all exceeded expectations for January. While expectations were not high due to weaker trends in December, that data suggests to us again that Omicron headwinds are fading, and also that consumers and businesses are navigating through inflationary pressures. While inflation remains a risk to the 2022 GDP outlook, the FactSet consensus GDP estimate for 2Q22 is 4.1%, vs. 2.0% in 1Q22.
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Market Indices: The information on indices is presented for illustrative purposes only and is not intended to imply the potential performance of any fund or investment. Indices provide a general source of information on how various market segments and types of investments have performed in the past. Index performance assumes the reinvestment of all distributions, but does not assume any transaction costs, taxes, management fees, or other expenses. You may not invest directly in an index. Past performance is not an indicator of future results. The S&P 500 Index is a market cap weighted index that is designed to measure the US large-cap equity performance. The index is composed of the 500 leading publically traded US companies based on size, liquidity, industry, and profitability criteria. The Dow Jones Industrial Average is a price weighted index that tracks 30 large, publicly-owned companies trading on the New York Stock Exchange (NYSE) and the NASDAQ. The NASDAQ Composite Index measures all NASDAQ domestic and international based common type stocks listed on The NASDAQ Stock Market. Today the NASDAQ Composite includes over 3,000 companies. The Russell 2000® Index is a market cap weighted index that measures the performance of the 2,000 smallest companies in the Russell 3000® Index. The MSCI EAFE® Index (Europe, Austral, Asia, Far East) is a free float-adjusted market capitalization index that is designed to measure developed market equity performance, excluding the US and Canada. The MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance in the global emerging markets. Bloomberg Commodity Index (BCOM) is calculated on an excess return basis and reflects commodity futures price movements. The index rebalances annually weighted 2/3 by trading volume and 1/3 by world production and weight-caps are applied at the commodity, sector and group level for diversification. The Bloomberg Barclays U.S. Aggregate Bond Index is a broad-based flagship benchmark that measures the investment grade, U.S. dollar-denominated, fixed-rate taxable bond market.
Price returns reflect market appreciation or depreciation excluding the reinvestment of capital gains, dividends, interest and other income.
The forward S&P 500 price-to-earnings ratio (P/E) is a valuation measure, calculated by dividing the price of the S&P 500 index over the weighted average earnings per share (EPS) estimate of each company in the index. Earnings are based on “forward” consensus estimates expected over the next 12 months (NTM) as compiled by FactSet.
Gross Domestic Product (GDP) refers to the monetary measure of the market value of all final goods and services produced within a country’s borders within a specific time period. Real GDP numbers are adjusted for inflation. GDP data are compiled by the U.S. Bureau of Economic Analysis; GDP estimates are from FactSet consensus of Wall Street economists.
STR provides premium data benchmarking, analytics and marketplace insights for the global hospitality industry. STR’s world-leading hotel performance sample comprises 73,000 properties and 9.6 million rooms around the globe.
The Bureau of Labor Statistics (BLS) compiles U.S. labor statistics from two monthly surveys. Personal Income measures the income people receive from wages and salaries, Social Security, and other government benefits, dividends, business ownership, and other sources. Seasonally adjusted annual rate (SAAR) is used to normalize data by adjusting for seasonal changes in business and economic data for a more accurate comparison between different time periods. U.S. Personal Spending (Personal Consumption Expenditures, or PCE) is an indicator of the growth in consumer spending.
The Bureau of Labor Statistics (BLS) compiles U.S. labor statistics from two monthly surveys. The household survey measures labor force status by demographics; the establishment survey measures nonfarm employment and data by industry. The nonfarm payrolls component of the establishment survey are drawn from private businesses and government entities. The nonfarm payrolls number is among the most widely used data points to assess U.S. employment trends. The unemployment rate is the percentage of the labor force that is jobless and actively willing and available to work.
The U.S. Census Bureau conducts the Advance Monthly Sales for Retail and Food Services Survey (MARTS) to produce early national estimates of total and month-to-month change in sales for retail and food service establishments located in the United States. A retail establishment is one that sells merchandise to the general public (final consumers). The estimates from MARTS are released approximately ten business days after the end of the reference month and are revised one month later by estimates from the Monthly Retail Trade and Food Services Survey (MRTS).
The Federal Reserve's reports a monthly index of industrial production and the related capacity indexes and capacity utilization rates cover manufacturing, mining, and electric and gas utilities. The industrial sector, together with construction, accounts for the bulk of the variation in national output over the course of the business cycle. The production index measures real output and is expressed as a percentage of real output in a base year, currently 2017.
The IHS Markit Manufacturing PMI is a composite index based on a weighted combination of five survey variables. The US Services PMI™ (Purchasing Managers’ Index™) is produced by IHS Markit and is based on original survey data collected from a representative panel of over 400 companies based in the US service sector. The flash estimate is typically based on approximately 85%-90% of total PMI survey responses each month and is designed to provide an accurate advance indication of the final PMI data.