You can count Barclays in the camp that thinks the U.S. equity rally has further to run through year end.
Earlier this week, the S&P pushed to a fresh all-time high amid a five-day losing streak in the dollar, which helped reignite global risk sentiment.
Why mention the dollar there? Well, because going forward, a weaker dollar could indirectly help sustain the stateside rally by helping to mitigate the headwinds facing ex-U.S. assets and thereby heading off a scenario where international turmoil finally boomerangs back to Wall Street.
U.S. fiscal policy is at the heart of recent dollar strength. Late-cycle stimulus raises the specter of an inflation overshoot, prompting hawkishness from the Fed, which in turn moves rate differentials in favor of the greenback. Meanwhile, the sugar high from that same stimulus leads to divergent growth outcomes with the U.S. economy firing on all cylinders while the rest of the world labors under the threat of a trade war. In emerging markets, dollar strength forces developing economy central banks to hike rates in order to protect their currencies, but those hikes serve to dampen domestic growth.
(Aside: there are a number of other USD+ dynamics embedded in U.S. fiscal policy including, for instance, repatriation effects).
Of course part of that late-cycle stimulus is the tax cuts and those tax cuts have supercharged corporate buybacks and thereby ensured that U.S. equities remain insulated from bear markets in EM, European financials, European autos, copper, and on and on. Stimulus has also helped U.S. corporates report record earnings, underpinning the rally further and ensuring its validity vis-à-vis fundamentals.
But if the buybacks fade and the sugar high from stimulus begins to wear off, well then it’s possible that U.S. stocks finally catch down to the rest of the world’s reality, which is why risk sentiment could really use a weaker dollar right about now.
So that’s the macro picture and that explains why the likes of JPMorgan’s Marko Kolanovic believe a weaker dollar and/or a Fed pause will be key going forward.
But Barclays’ decision to raise their year-end price target on the S&P to 3,000 from 2,900 doesn’t revolve around a prediction about a dovish lean from the Fed or a weaker greenback. Rather, the bank’s new price target is based on a decision to transition to a new model.
As it turns out, had Barclays stuck to their old model, they would have needed to actually cut their S&P target to 2,825, which is pretty inconvenient considering we’re already there. Under the old model, the softening macro environment would have caused problems, including a decline in the bank’s “‘fair value’ of PE” and a drop in the value of their “top down model’s ‘pure growth’ factor and ‘pure inflation’ factor.”
(Barclays)
Here’s Barclays to explain further:
Overall, the decline in the macro environment would have decreased our 2018 bottom-up EPS target, kept our top-down EPS target relatively flat, and decreased our projected P/E for calendar year 2018. Despite the strong increase in consensus earnings, our price target would have declined under our current model (from 2900 to ~2825) stemming from lower EPS and PE targets.
That’s no good, so naturally, Barclays just came up with another model because (and this is a quote), “our EPS model suffered from not being able to incorporate realized EPS.”
Now look, if you read the full note (which is lengthy), there’s a good explanation for this and if you’re making forecasts about a benchmark, you’re obviously going to need to make some assumptions (i.e., forward-looking guesstimates) about earnings. But that doesn’t make it any less amusing that the bank’s “EPS model suffered from not being able to incorporate” actual earnings per share. Here’s Barclays elaborating:
Under our 12-month (or annual) forecast models we attempted to model changes in P/E and EPS over a time frame of 12-months. This would clearly result in consistent projections for the forward 12-months, but to projected calendar year changes we had to make certain assumptions that are better handled under a quarterly projection model. The biggest shortcoming of our annual model when applied to fiscal calendars is that it could not incorporate actual earnings for the calendar year forecast. So as Q1 and Q2 EPS were reported our top-down and bottom-up EPS models would not incorporate these realized earnings. They would simply take updated 2018 consensus EPS and economic forecasts and, without separating out the realized portion of the forecasts, use these numbers to calculate updated bottom-up and top-down EPS forecasts.
Long story short, they fixed that. “In contrast to the annual model, our new quarterly bottom model explicitly forecasts Quarterly YoY% growth for the next four quarters”, the bank writes, adding that “another notable advantage of our transitioning to a quarterly model is the ability to see how the EPS growth is distributed over the year.”
As it turns out, the new model is good at predicting EPS growth for the next three quarters, but not so great when it comes to making projections four quarters ahead. There’s some discussion around that too, but ultimately, the bank says this:
As we progress through the year our CY2018 EPS estimates are a combination of realized Quarterly EPS (currently Q1 and Q2 for 2018) and the remaining forecasted Quarters (currently Q3 and Q4). Thus, this new method allows us to incorporate both realized and forecasted quarterly values, creating a cleaner model.
After tweaking their P/E model too, they end up with a “better” year-end SPX target. Here’s the bottom line (figuratively and literally in this case):
The incorporation of the new model leads to higher EPS projections ($162 now vs $157 previously) and a higher P/E multiple (18.7x vs 18.0x). With our new model we reach a 2018 YE Forecast SPX Price Target of 3000 (rounded down from 3029), with a projected EPS of $162 and an effective P/E ratio of 18.5x (rounded down from 18.7x).
Here’s the next 12 months breakdown:
There you go. That’s how you model your way to a higher price target for an entire index when the current model isn’t “working” like it should.
Sarcasm aside, there are good reasons to remain near-term bullish including, of course, buybacks, robust earnings and still solid data (although the Citi economic surprise index for the U.S. is trending notably lower), so this isn’t entirely farcical. Obviously, you want to try and take account of reality, which in this case means fantastic bottom line growth for U.S. corporates.
That said, there’s a veritable laundry list of reasons to be cautious including the prospect of a Fed that sticks to its hawkish guns in spite of Donald Trump on the way to pushing the dollar ever higher and exacerbating an unwind in EM.
Oh, and it’s possible the U.S. President gets indicted or impeached, which, if you believe him, would catalyze a “crash” and leave everyone “very poor.“
