High valuations, inflation pose risks to stock market

Earnings could surprise to the downside

Fourth-quarter earnings season is just around the corner. Is there any reason to be concerned about the pace of earnnigs growth we’ve seen so far? Earnings at S&P 500 companies grew around 35% year on year in the third quarter, even with constraints from supply chain issues and rising input prices due to higher commodity and labour costs. Even so, the stock market remains highly valued with the S&P 500 Composite Index selling at 32.4 times estimated earnings, and on a cyclically adjusted basis, such as the well known CAPE/Shiller calculation, stocks are selling at record high valuations, even higher than at the peak of the technology bubble in 1999-2000.

It was to be expected that companies in North America and Europe would be posting strong growth in earnings on a year on year basis, as the third quarter of 2020 was a period when the Covid-19 pandemic effects were still widespread, with outbreaks in the southern U.S. causing local lockdowns to be reimposed in many states.

So far, results from many industrial companies such as GE and UPS are stronger than anticipated, although some companies such as FedEx and Northrop Grumman have sold down on what were regarded as disappointing earnings. Amongst the reasons for the disappointments were supply chain issues, with many components and finished products stuck at ports such as Los Angeles/Long Beach in the U.S. as capacity has been overwhelmed by the surge in demand for goods from consumers spending their increased savings from government support programmes. The inability to spend on services such as restaurants, hospitality and travel has also pushed spending into consumer durables and consumables at a time when supply has been reduced by such factors as microchip shortages and Covid-induced shutdowns of manufacturing plants, particularly in China and Asia.

The major technology companies such as the FAANG+ stocks (Meta Platforms, formerly Facebook, Amazon, Apple, Netflix, Google-parent Alphabet, and Microsoft) have been less affected by many of these issues, although Apple reduced its forecast production of iPhones by 10 million. The large increase in expenditures by Amazon to expand its distribution network has run into rising costs for labour and equipment, while the anti trust legislation and higher taxes being contemplated by the U.S. Congress and the European Union poses a longer term threat to the quasi monopoly power enjoyed by the tech giants.

Meta Platforms’ revenue forecast for the fourth quarter of 2021 was lower than expected, reflecting lower advertising spending by companies on changes to Apple’s data collection policies, as reported by Snapchat’s parent. With accusation of predatory marketing through its algorithms, Facebook’s shares are down 12% from its September high, and its market capitalization has fallen below $1 trillion.

While the earnings from the tech giants continue to remain strong, with trailing price-earnings ratios (as of Dec. 22) ranging from 67 times for Amazon, through 37 times for Microsoft, 28 times for Alphabet, 31 times for Apple, and 24 times for Meta Platforms, let alone 328 times for Tesla, they remain highly valued and vulnerable to any decline in their earnings growth. Having had the perfect environment for earnings in the last year and a half, with lockdowns and the absence of services to spend money on driving consumers to tech platforms for streaming, ecommerce, and working from home, inevitably some of this spending is now reallocating to physical retailing, travel, and hospitality.

The rise in the price of commodities, not merely energy but also materials and foods, reflects reduced supply meeting increased demand, a classic recipe for inflation. The continued shortage of labour driving up demand for workers, in what some have called the “Great Retirement,” has taken many potential employees out of the workforce, thus causing wages to rise, an inflationary psychology that risks becoming embedded. Even central bankers such as the Federal Reserve’s Jay Powell have changed their tune that inflationary pressures are transitory, and are now acknowledging that the supply chain issues and higher commodity prices may remain present for longer than anticipated leading to inflation well above their 2% long-term target persisting into the New Year.

Investment implications

If inflationary pressures do remain higher, then company earnings may be at risk of coming in below elevated investor expectations, with shares that do disappoint selling off sharply, in some cases by between 15% and 25% in a couple of sessions. Investors should consult their financial advisors about which sectors may offer some protection from these pricing pressures. These include commodity-related sectors, such as energy and materials, particularly the gold mining stocks, (the only materials sector to be down over the last year), as well as real estate, utilities, and pipelines, which enjoy inflation-linked contracts.

Gavin Graham is a veteran financial analyst and money manager and a specialist in international investing, with over 35 years’ experience in global investment management. He is the host of the Indepth Investing Podcast.

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