U.S. equities, as measured by the S&P 500 Index, returned less than 1% in the quarter, including dividends, bringing year-to-date performance to +16%. Non-U.S. stocks, as measured by MSCI’s All Country Worldwide Ex-U.S. benchmark, fell 3% including dividends, ending the third quarter up 6% on a year-to-date basis.
Below the calm surface, however, the waters were turbulent. The number of different market-driving news events in the third quarter alone was enough to make one’s head spin. Depending on the day, and with little notice, the narrative would shift and the herd of talking heads and short-term oriented investors followed suit. Delta variant, Chinese crackdowns on tech giants, Federal Reserve chatter on interest rates, inflation, stock price valuations, supply chain disruptions, microchip shortages, tax reform. The list goes on. When trying to make sense of it all, and interpreting market reactions as investors’ attention jumps to and fro, we look to earnings. Stock prices tend to follow forward earnings expectations.
This makes sense, as from the most basic, theoretical perspective, a company’s stock price reflects the present value of future earnings of the business. So when thinking about where stock prices have come from, how media events of the day are driving market volatility, and where stock prices may go from here, we believe it is most helpful to view events through the lens of how individual or combinations of events impact the outlook for corporate profits.
We saw this play out in the third quarter in a few ways. First, as fears increased over the Delta variant causing a reduction in economic activity, investors worried that future earnings growth would
not be as robust as previously expected. This investor concern caused stocks to weaken on days when their fears were front and center. At times when the Delta variant seemed to be under control,
investors breathed a sigh of relief and the market tended to go up, at least when other headwinds were not supplanting the Delta variant. Second, when supply chain disruptions and rising inflation took center stage, the markets tended to sell off on fears of lower than expected sales forecasts due to missed opportunities from supply chain disruptions, and margin pressure from rising costs.
In the context of earnings driving the market, the S&P 500 Index’s year-to-date total return of 16% through the end of the third quarter makes sense. Expectations for the Index’s 2021 earnings per share have risen 20% to $199 as of September 30 versus $165 at the end of 2020. In addition, expectations for 2022 earnings have risen more than 20% since the beginning of the year.
From a valuation perspective, the U.S. stock market, as measured by the S&P 500 Index, now trades at 22x calendar year 2021 and 20x 2022 earnings. Many market participants feel these price/earnings (P/E) multiples portend trouble ahead, and we fully admit stock valuations are near the high end of their historical range. However, in the context of historically low interest rates and a technology-dominant economy, we view stock valuations as making some sense – even if they are uncomfortably high in absolute terms – and we would not expect valuations to fall a lot if earnings estimates continue to climb and interest rates do not rise significantly from today’s levels.
Those are some big “ifs,” which is why Howland Capital remains steadfastly focused in our clients’ portfolios on trying to own the best positioned stocks. The ability to achieve forward earnings estimates is key for companies to sustain relative stock price performance. In today’s rising inflation and volatile interest rate environment, we are focused on owning well-run, high quality businesses with secular growth tailwinds propelling their earnings and free cash flow higher.
In terms of where we think stocks go from here, the short-term outlook is anyone’s guess and, frankly, this is not our priority. Our focus is on the long-term outlook for corporate profits – on businesses and management teams that have a track record of reliably delivering on expectations through the economic cycles. We believe this focus will best serve our clients’ interests over a full investment horizon. The pace of the post-COVID economic recovery has been significant, and trends like these tend to be longer-lasting in the absence of additional shocks.
We also view equities – even in spite of elevated valuations – to be far more attractive than bonds. For these reasons, we remain committed to owning both domestic and international stocks in our clients’ portfolios.
We practice discipline at the asset class level, prudently allocating assets according to each client’s individual risk tolerance. It is at the heart of what we do, and we encourage open dialogue with
all clients should their changing circumstances warrant modifications to portfolio positioning.