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As the Dow closes above 33,000 for the first time, skeptics see red flags

March 18, 2021, 12:30 AM UTC

Unless rampaging profits ride to the rescue, the stock market’s in big trouble. For the ultra-bullish scenario to triumph, earnings would need to devour a seemingly impossible share of the economy. The Wall Street pros claim the profit bonanza is in the bag. For investors, following that leap-of-faith forecast could mean leaping off a cliff.

The explosion in big-cap stock prices during the COVID pandemic is a total departure from the trend that reigned in the years preceding the cataclysm. From mid-2016 to the close of 2019, the S&P 500 rose practically in lockstep with earnings-per-share that grew consistently at an annual clip of 15%. In those three-and-a-half golden years, the S&P rose 54% to 3231, and profits waxed even more, by 60% from $86.92 a share to an all-time peak of $139.47. Because earnings were so strong, the enthusiasts didn’t fret over what appeared as pricey valuations. During that span, the S&P’s price-to-earnings (PE) multiple actually fell slightly, from 25.3 to 23.2.

The bull case held that profits would keep climbing at double digits, and what Wall Street portrayed as moderate multiples would at least hold steady, if not increase. An index advancing at well over 10% a year appeared the new normal.

The COVID crisis, of course, exploded the expectations for profits, but not for prices––the S&P kept dancing to its own, jaunty beat. It’s obvious that pandemic-driven collapse in earnings is a one-off disaster, and that profits will recover. But here’s the rub: Earnings-per-share must roar back to levels well above their pre-COVID records for valuations to look even remotely reasonable. If that doesn’t happen, shareholders will be caught like Wile E. Coyote spinning his wheels over that cavernous ravine.

The analysts polled by S&P predict that profits for 2021 will hit $157.12 per share. That’s a big, 12.7% rise over the 2019 summit. (We’ll use Q4 of 2019 as the benchmark, since it’s where earnings stood prior to the lockdown.) Even if we assume that the S&P goes flat following its Saint Patrick’s Day close of 3970 for the remainder of 2021, it would end the year at a P/E of 25.3. That’s nearly 10% more expensive than in Q4 of 2019, when its multiple was already higher than at virtually any time since the end of the Great Recession.

Wall Street’s forecasts for earnings are almost always too rosy. But if you truly believe that the S&P is still a buy, you also have to believe that $157 a share, or even more, is eminently achievable. What are the chances of getting there? A excellent gauge is measuring the S&P’s total value versus the U.S. economy. That exercise comes in two parts. The first is determining whether its share of national income was low or inflated at the starting point––in our case at the end of 2019. The second is estimating where the ratio of profits to national income would finish this year if the Wall Street forecasts that stocks will advance briskly from here are correct.

The first measure isn’t reassuring. Earnings were already extremely high by historical standards in Q4 of 2019. The S&P’s combined market cap equaled 126% of GDP. That’s over one-fourth higher than the 99% reading in mid-2016, when we were already well into the historic boom. The CAPE ratio, invented by economist Robert Shiller, suggests that EPS in 2019 stood 10% to 15% above their long-term trend in late 2019. That suggests that S&P 500 profits were already unsustainably high.

Second, it’s true that the U.S. will enjoy a big growth spurt this year. The Congressional Budget Office predicts GDP will rise at 6.3% in 2021 over last year, including inflation. Sounds pretty good. But take this into account: That 2021 projection represents just a slender 3.8% increase over where national income stood in 2019. A highly optimistic projection would show EPS rising arm-in-arm with GDP over that two-year period by 3.8%. If we start with pre-pandemic benchmark S&P profits of $139.47 in Q4 of 2019, we’d reach $145 by the close of this year.

In that still hopeful forecast, if stocks go sideways for the rest of the year, the S&P’s P/E would finish at 27.6, 19% higher than its pre-COVID level, and almost 40% above the 30-year, pre-COVID average. But that’s not at all what Wall Street’s predicting. The market strategists at Goldman Sachs, Credit Suisse, and JPMorgan Chase all see the index rising more than 8% from here. If it indeed hits the Goldman and Credit Suisse targets of 4300, the multiple, based on earnings of $146, will hit 29.5.

The clincher is the amount of GDP that profits would need to consume. Even assuming the S&P stalls right here at 3970, it would have a total valuation of $34 trillion at year-end. That’s 152% of projected GDP for this year, a figure that’s one-fifth above the ratio at the peak of the tech bubble in early 2000. If the Goldman and Credit Suisse forecasts are correct, the ratio would reach 165%. We’ve never seen a numbers like that before, and we’re unlikely to this time. That outcome would mean much less income going to labor, and tons more flowing to the shareholder class. It won’t happen.

It’s the realization that profits can’t grow to the sky that will end the bull market. And the longer this craziness goes on, the worse the reckoning to come.

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