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Tuesday, May 4, 2021

Price targets and economic forecasts fall behind

Readers of the Morning Brief know investor expectations were high ahead of earnings season, that companies have topped expectations at a record rate, and that the economy is firing on all cylinders.

And these events have pushed Wall Street strategists back into another theme we've written about in this space for the last few months — trying to keep up with the market.

Late last week, Credit Suisse chief equity strategist Jonathan Golub raised his price target for the S&P 500 to 4,600 from 4,300, writing that a "red hot economy" is fueling corporate earnings beats.

"Consensus GDP forecasts call for 6.3% real (8.6% nominal) growth in 2021, the fastest pace in nearly 4 decades," Golub writes. "Every 1% improvement in nominal GDP translates to a 2.5%-3% gain in S&P 500 revenues, and additional improvement in margins, as fixed expenses are amortized over greater sales volumes. While companies might bemoan higher input costs, history shows that rising commodity prices lead to margin upside as companies pass on additional costs." (Emphasis ours.)

Golub also cites operating leverage — which we covered earlier this year — both as a driver for corporate profits this cycle and a factor still under-appreciated by investors. Most simply stated, operating leverage is the ability for companies to earn incremental profits on higher sales. And so if, for example, every dollar of sales cost a company 50 cents, a firm exhibiting high operating leverage would see lower costs on additional revenue, resulting in its bottom line growing at a faster rate than sales.

At the beginning of economic cycles, Golub notes that higher-than-anticipated operating leverage results in consistent upward revisions to earnings forecasts for potentially two or three years. Seen this way, the strong earnings cycle coming out of the pandemic-induced recession is only just getting started.

And while Golub's work certainly frames the economy's strength as an upward driver for markets, we'd be remiss not to mention recent work covered by the Morning Brief from Goldman Sachs and Deutsche Bank suggesting that economic growth is peaking, a potentially troubling sign for stocks.

Moreover, while faster-than-expected economic growth is a good problem to have, it seems some parts of the economy are reaching their limits. A dynamic that seems likely to either slow growth, drive inflation, or both. On Monday, the latest data on manufacturing activity from the Institute for Supply Management showed the manufacturing sector grew at a slower pace than expected in April as lead times increased, prices rose, and labor and commodity shortages persisted.

"Recent record-long lead times, wide-scale shortages of critical basic materials, rising commodities prices and difficulties in transporting products are continuing to affect all segments of the manufacturing economy," said Tim Fiore, chair of Institute for Supply Management manufacturing business survey. "Worker absenteeism, short-term shutdowns due to part shortages, and difficulties in filling open positions continue to be issues that limit manufacturing-growth potential."

By Myles Udland is a reporter and anchor for Yahoo Finance Live. Follow him at @MylesUdland

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