Navigating the Outlook for U.S. Equities

Text transcript

Jeff Agne, I’m a managing director at Rothschild Asset Management and a co–portfolio manager of the large-cap value product.

So, in terms of corporate profits, what are the market’s expectations for growth this year? Let’s start with what we’ve just been through over the last couple of years, just so we have some context.

In 2019 the S&P 500 EPS was about $163, which fell about 13% to $142 in 2020 due to the pandemic. Now, looking forward in 2021, the Street’s looking for about $188 in earnings and then in 2022, when the economy is perhaps a little bit more normalized, the Street’s looking for about $210 in earnings.

So, if we focus on 2022, the market’s looking for about 10% earnings growth versus 2021, and almost 28% earnings growth versus what we saw in 2019 just before the pandemic hit. Now, those are some pretty healthy growth rates, and it’s possible we’ll even see continued positive revisions to numbers in both 2021 and 2022.

In terms of more recent profit trends, we just went through one Q21 earnings season, and generally speaking, earning results are past expectations and forward commentaries are supportive of the idea that the economy is going to continue to rebound. Most companies are seeing sequential improvements in demand and if anything the lack of inventory in some industries is preventing numbers from being even higher.

Now, with that said, expectations have certainly risen, and we saw that as we went through earnings season. What I mean by that is we saw plenty of cases where a company reported positive results, but the stocks didn’t react accordingly. And in many cases, we saw a lot of the, quote, sell the news. So again, we think there’s already a lot of good news baked into stocks at these levels.

So, value stocks have finally taken over a leadership role in 2021, which reverses a trend we’ve seen for the last number of years, if not the most of the last decade. So far in 2021, the Russell 1000 Value Index is up about 17.5% versus just 6.5% for the Russell 1000 Growth Index. But what’s interesting is that, on a relative valuation basis, growth stocks are still trading at a premium. Relative to the S&P 500, growth stocks are still trading at about a 21% premium to the market, while value stocks are trading at a 16% discount. So, while the gap has narrowed in terms of performance and relative valuation, we think there could be room to run for value stocks.

And in addition, key pieces of the economy that are tied to higher rates and the continuation of the reopening trade — places like financials, energy and parts of the industrial complex, for example — those make up a large percentage of the value index.

But regardless of style, we continue to look for names where we see upside to earnings estimates and where valuation is attractive relative to peers.

So, what else can investors expect? In a word, I would say volatility. While there’s many signs the economy is healing, we do expect to hit some bumps along the way, and we’ve already seen some of those bumps. For example, the jobs number we got in early May was very surprising; it split the market, at least in the short term. We’ve also seen a few inflation scares in recent months. So, while we can’t predict where the market’s headed, we almost certainly expect more volatility along the way as we move through this pandemic. And I guess the pandemic itself is still another wild card. While things are improving in the U.S., there are still many countries globally that are still battling this virus. And of course it’s possible a new variant will arise in the U.S. that reverses some of the progress that we’ve made, but let’s hope that doesn’t happen. And so far, these vaccines look pretty effective versus the number of the virus variants that we’ve seen.

So, the other thing I would mention is that we’re just a few months into a new presidential administration, and that can certainly introduce new unknowns into the market. If we take the corporate tax rate, for example, Democrats are pushing for a rate in the high 20s while Republicans are angling for something closer to the low 20s. Perhaps we’ll see a compromise somewhere in the middle, if a compromise is possible in Washington anymore.

But beyond taxes, there’s an infrastructure building negotiated, and policy and budgetary pressures that could impact anything from the energy industry to the defence sector. And that’s really just the beginning of it. So, policy changes out of Washington are certainly something we’re keeping an eye on.

One stock we remain constructive on is AbbVie, which is a large biopharmaceutical company with a market cap of about $200 billion. The company has dominant franchises in various inflammation markets — think arthritis and psoriasis — in blood cancers like lymphoma and leukemia, and in the pharmaceutical aesthetics market — think Botox. While the company’s largest drug, Humira, is facing a patent cliff, we think AbbVie has several new products that are now in the market that will help offset a lot of Humira’s lost revenue. These new products continue to surpass expectations and have put upward pressure on earnings estimates. And as these new products become a bigger part of the revenue mix of the company, we think that warrants a higher PE multiple on the stock relative to today’s multiple of just 8.3 times 2022 estimates. We think there’s also an underappreciated margin story here, with recent management commentaries suggesting confidence in their ability to continue to streamline the business.

And last but not least, we like the company’s cash-flow profile and their commitment to continue to grow their dividend, which yields an attractive 4.5% today.

Have we exited any positions lately? We have.

First, we sold our position in Discovery Communications, which is the media company behind popular TV shows like HGTV, the Food Network and of course the Discovery Channel. Shares really performed well as enthusiasm grew for their Discovery+ offering and as the TV advertising business was showing signs of recovery. TV advertising is a huge revenue driver for this company and for many media companies.

However, after shares rerated, we felt the stock was fairly valued and that enthusiasm for the company’s Discovery+ offering was adequately reflected in expectation. It’s interesting. We’ve since seen the price of the stock fall dramatically following the Archegos hedge fund incident and, more recently, on the announced merger with AT&T media assets. Another stock we sold is Pulte Homes, one of the nation’s leading homebuilders, with exposure to various verticals in the market, including first-time home buyers, move-ups and the over 55 category.

We exited our position after shares outperformed the market and the consumer discretionary sector over the last 12 months. We think the bar is very high with consensus revenue growth expectations of almost 35% for the next year.

And as long-term U.S. Treasury yields began rising sharply earlier this year, the risk that mortgage rates would creep higher also rose, which could dampen housing demand.

Significant price appreciation over the last year has also introduced some concerns about affordability in the housing market. And from our perspective, it’s hard to see market conditions getting better from what could be one of the strongest backdrops ever for U.S. housing.