Some thoughts on 3Q so far and what to expect:
-Banks kick off earnings season with decent beats, but point to ongoing NIM
pressures, even with a Dec Fed rate hike, and other macro and regulatory
challenges to achieving good EPS growth in 2017. We expect the rest of 3Q
reporting season to be even more sobering. Most companies will beat the last
minute estimates, but beats will be smaller than usual and 4Q16 and 2017 EPS
outlooks will be tempered. The greatest risk of disappointment is at Consumer
stocks, Industrials, Materials and even Energy despite low expectations. We
believe Tech & HC will have among the more encouraging results and outlook.
3Q S&P EPS is likely ~$30.00 or flat y/y or up 3% ex. Energy, Fin & Real Estate
Today’s bottom-up aggregate analyst 3Q EPS estimate for S&P constituent companies as of Sept end is $29.98, which compares to $30.12 in 3Q last year. On a current constituent basis, we expect S&P EPS flat y/y or up 2% q/q. 3Q EPS growth should be 3% ex Energy or ex Energy, Fin & RE. S&P EPS growth ex. Energy, Fin & RE has slowed in recent quarters to ~3% and 3-5% seems most likely for 4Q16 & 2017. Oil prices remain a wild card for 2017, but we expect oil to avg. $55/bbl and the Energy sector to earn $48bn. The aggregate market cap of the Energy sector is $1.35trn or 28x 2017E EPS.
The direction of fundamentals matters, but what’s priced in matters most
In recent weeks, spot oil climbed to a bit over $50/bbl and 10yr Treasury yields climbed to slightly exceed 1.75%. Rising oil is good for Energy earnings and rising long-term yields better compete with dividend yields, but the direction of such fundamentals must be judged relative to the destination expected or priced by the stocks via their valuation. In the case of Energy, we believe oil must climb to $70/bbl by 2018 to justify today’s observed valuations and make their forward PE fall to about 15-16 by 2017 end from 28 today. Because we’re skeptical of $70/bbl oil in 2018, ~$60/bbl seen as more likely, we think the Energy sector will be flat to down 20% in 12-months. In the case of Utilities, we think 10yr Tsy yields must climb to 4.5% in 2018 to make the sector’s 17x forward PE fair. Because we expect the 10yr yields to stay below 2.5% in 2018, and real long-term yields not to exceed 1% for many more years, we think a 20-22 forward PE (3.0% div yield) is fair for Utilities suggesting 15-25% upside.
Consider CAPM in a 1% real Rf rate world: High dividend cyclical most at risk
Right now, 10yr TIPS yield 10bp, up from 0bp a few weeks ago, which suggests the 25bp climb in 10yr yields is mostly from higher expected inflation. PEs are influenced by real interest rates and a fair real cost of equity. We value the S&P by assuming 10yr TIPS will yield 1.0-1.5% around 2025. To this expected “normal” real Rf rate, we add a 400bp Equity Risk Premium to estimate the S&P’s overall real Ke at 5.0-5.5%. By sector, we adjust the ERP depending on its beta or cyclicality. By this method, the real Ke for defensive sectors with a 0.8 beta is 4.5% and for cyclical sectors with a beta of 1.2 about 6%. This suggest that a fair PE on normalized trailing non-GAAP S&P EPS is ~18.5 (1/real Ke), but 21-23x for most defensives and 15-17 for most cyclical sectors (1/real Ke). We don’t think low beta bond substitutes are overvalued, rather we fear many cyclicals with 3%+ dividend yields are pricey because investors are overlooking macro risks and challenges for 3%+ dividend yields.