Higher interest rates can make investors less willing to pay rich valuations for shares. This means that corporate profits will be crucial to sustain the market’s momentum.
Lower interest rates make investors more willing to pay rich valuations for stocks, and equity valuations hit higher levels in 2020 after the Fed slashed its benchmark rate to near zero. In 2021, the price-to-earnings multiplier remained above the longer-term norm but began to move lower. Now that rising rates are in trend, potentially causing multiples to contract further, investors are rethinking their game plans. This means that earnings growth will be significant for the market to continue its uptrend.
“Given where the multipliers are today, you need continued growth to keep the rally going,” said Mike Stritch, chief investment officer at BMO Wealth Management. “Even if interest rates weren’t going up, I think we were at the high end of what people would be willing to pay to earn a dollar.”
Investors will get a first look at the state of corporate profits when several financial companies report later this week. JPMorgan Chase & Company, Citigroup Inc.
And Wells Fargo & Company reports Friday and could serve as a bellwether for the health of the broader economy. Delta Airlines Inc.,
which reports on Thursday, could help investors understand how airlines are handling a Covid-19 surge.
Next week, companies including freight giant JB Hunt Transport Services Inc.,
Consumer-Products Company Procter & Gamble Co.
and oil-field-services company Baker Hughes Co.
are expected to report.
Analysts expect profits of companies in the S&P 500 to rise 22% in the fourth quarter from a year ago, according to FactSet. This would be a higher-than-average growth rate, but much lower than in the past few quarters, when the results were being compared to profits at the start of the pandemic. For example, in the second quarter of 2021, the S&P 500 grew 91% in earnings.
The return to earth is expected to continue in the new year. Earnings for S&P 500 companies are expected to grow 9.4% in 2022, a slower pace than the 45% profit growth projected for the year 2021. In 2019, the last full year before Covid-19 began to impact the US economy, profits rose nearly 0.1% for the year.
Investors scrutinizing corporate results in the coming weeks will look not only at the bottom line but how the companies got there. While managers are faced with rising costs of everything from raw materials to labor to shipping, many have been able to overcome the expenses by raising their own prices.
According to FactSet, net profit margin for the S&P 500 peaked at 13.1% in the second quarter of 2021, the highest level in figures going back to 2008. It slipped to 12.9% in the third quarter and is expected to fall to 11.9% in the fourth quarter.
How executives talk about the coming months could have the biggest impact on the markets. Investors will want to know how the spread of the Omicron variant could continue to impact the business. And they’ll be curious to know how companies manage wage increases and higher transportation costs, among other expenses.
“I think from a guidance perspective, it could be very difficult for the companies here in 2022,” said Jimmy Chang, chief investment officer at Rockefeller Global Family Office. “All these input costs have increased significantly over the last year.”
The stakes are especially high for growth stocks, which trade at heavy multiples because they promise to expand future profits. Rising yields can hurt especially valuable stocks because higher returns put pressure on the value of companies’ future cash flows. Higher returns also give investors more choices about where to put their money to profit, making them less willing to take risks on stocks.
Many growth stocks are found in the technology sector, which are expected to report lower earnings growth in the fourth quarter than the stock index as a whole. The tech sector last week traded at 27.1 times its expected earnings over the next 12 months, which is more than a multiple of 20.7 times the S&P 500. By comparison, the Energy Group traded at 11.9 times its estimated earnings and the Financial Group traded at 15.2 times.
During last week’s trading, the tech sector declined 4.7%, while energy gained 11% and financials up 5.4%.
“Especially given the valuation of some technology, there’s not a lot of room for error here,” said Linda Bakshian, a senior portfolio manager at Federated Hermes, which focuses on value-style stocks. “So we really need those margins and his commentary to come through to support continued performance in 2022.”
Write Karen Langley at karen.langley@Businesshala.com
