The S&P 500 is off a third of a percent over the past week. That’s not an alarming decline, and perhaps not one that brings “sell in May and go away” to mind. Not yet anyway.
However, recent equity market lethargy coupled with concerns about rising inflation may give advisors and investors reasons to evaluate just how much stocks can run from here. Gauging the exact answer to that riddle could be a fool’s errand, but it’s worth noting equities aren’t exactly cheap today.
“Equity markets have rebounded rapidly since the drastic coronavirus-induced sell-off a year ago and have powered past pre-crisis levels. As a result, stock valuations are elevated, and many investors wonder if the rally will continue,” says Timothy Murray, T. Rowe Price capital markets strategist – multi-asset division.
With valuations looking frothy, the burden for more upside shifts to earnings growth. Indeed, expectations are in place for some marquee S&P 500 sectors to generate stout earnings growth this year. How much of that growth is already baked into equity prices is another matter.
“With extended valuations, hope for further upside mainly rests in earnings growth. Massive pent-up demand, robust fiscal stimulus, and the prospects of fully reopened economies are good reasons to expect strong earnings growth in 2021 and 2022,” notes Murray. “However, as shown in Figure 1, U.S. equity markets seem to have already priced in some of this expected earnings growth. Meanwhile, equity markets outside the U.S.—especially in emerging markets—appear to have more upside potential.”
On the bright side, upward earnings revisions are in play this year and in 2022 by virtue of the fact that the U.S. economy is emerging from the coronavirus-induced recession of 2020.
“Although positive revisions in earnings estimates could be supportive, most of the good news appears to be already priced into equity markets, and the upside potential going forward may be somewhat limited,” concludes Murray. “Therefore, the Asset Allocation Committee recently decreased overall equity exposure but maintained a tilt toward segments most sensitive to economic conditions—such as small-cap, value, and emerging markets equities—that could likely benefit from upward revisions in earnings estimates.”
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