This article is written exclusively for Investing.com
The reporting period for the second quarter is nearing its end and is much more robust than many expected. This has led analysts to lower earnings expectations for the . However, with the index trading at its highest PE ratio in over 20 years, everyone's question should be: was the quarter strong enough?
The S&P 500 is currently trading at 21.3 times expected earnings for the next 12 months. This is an extremely high valuation that can only be compared to the late 1990s. The PE ratio has so far been supported by strong earnings growth and accommodative monetary policy from the Fed. However, as we move forward, growth rates are expected to slow, and the Fed is likely to become more aggressive as the US economy continues to recover.
High PE ratio
Profit growth soared in 2021 as the US exited the lockdown phase of the coronavirus pandemic. This, coupled with accommodative monetary policy, helped the S&P 500 rise, increasing the index's PE ratio. So far, with the earnings season coming to an end, however, earnings revisions in 2022 have not been strong enough to bring the PE ratio down to levels that are more reasonable and sustainable, such as levels seen in the mid-teens before the pandemic.
S&P Forward EPS Estimates
Not Strong Enough
What has happened as this earnings season has progressed is that many of the earnings revisions have been loaded front-end, meaning they have added an increase in estimates towards 2021 and not beyond 2022. As a result, growth is expected to slow dramatically in 2022, by just 9.5%. It also means that the 12-month future earnings estimate will eventually reflect 2022 EPS estimates of $213.35 per share, which would give the index a PE ratio of 20.7, just slightly lower than the current 12. -month forward ratio.
It therefore seems clear that the solid second quarter results have not contributed enough to raising earnings expectations for 2022 to lower the index's valuation. Unless the 2022 earnings revisions start moving in any meaningful way, the index will face slowing earnings growth and a more aggressive Fed as the price trades at a peak PE ratio.
That could make things tricky for the S&P 500 as we move through the final four months of 2021, and investors start to think about how much they should be willing to pay for gains. Higher growth rates earn a higher PE, while lower growth rates earn a lower PE.
What's happening from here
What needs to happen from here is that earnings revisions continue to rise at a much faster pace. To bring the PE multiple for 2022 back to its pre-pandemic level of about 17 and to maintain the current level of 4,400 on the S&P 500, next year's earnings would need to rise to about $258 per share or $244 per share. to trade at a PE ratio of 18. Both seem hard to achieve as 2022 profits need to rise by at least 14% from current levels.
On the other hand, if profits do not rise, the S&P 500 value would have to fall 12.7% for the PE ratio to shrink to 18, or fall 17.5% to a PE of 17, or about 3,630 on the index.
Both scenarios seem extreme, but it tells us that despite an earnings season that was much better than expected, it wasn't good enough to help the market where it needed it most.
