On the heels of the busiest week of the Q2 earnings season, JPMorgan Chase & Co.’s equity quant said that U.S. stocks could continue to rally despite a decline in corporate profits.
Marko Kolanovic, the quantitative analyst whose team predicted the summer rebound and has been bullish on stocks for months, said in a weekly research note that this year’s drop in equity valuations has already exceeded the average pullback of similar periods of economic uncertainty. Valuations are already seeing a dramatic re-rating lower, he said, reporting that the price-to-earnings ratio over the next twelve months (NTM) was greater than that of any period for the past 30 years. The NTM is the most popular ratio used to express equity valuations.
The S&P 500’s NTM price-to-earnings multiple bottomed out around 15.5x during the pullback, a drop of nearly 7x its January peak. In March 2020, the S&P 500’s NTM price-to-earnings ratio hit a low of 13x.
Corporate profits have continued apace as the economy has shrunk during two consecutive quarters. According to FactSet, 73% of S&P 500 companies reported second-quarter statistics had beaten Wall Street analysts’ profit expectations. The five-year average is 77%.
If the National Bureau of Economic Research declares a recession, Kolanovic said, investors need not be too concerned about the effect on profits. Multiple compression, inspired by rising interest rates, has driven this year’s selloff of stocks.
Rising bond yields, though, could present difficulty, he said. They have typically meant lower equity valuations, and Kolanovic warned that a 10-year yield of 3.5% or greater could impact stocks, which become sensitive when GDP growth has been low.
Equity valuations should be stronger if a recession hits this year, Kolanovic wrote, with a trend toward higher quality companies in the S&P 500.
“While the current equity multiple of 16.9x is in line with historical median, we believe the market multiple is better than fairly valued given the shift in industry mix to higher-quality companies over the last two decades.”
