• Stocks advance on economic strength, confidence in durability of profits
  • Earnings comparisons become more difficult in second half
  • Secular bull market appears to be intact

The S&P 500 recorded a strong first half, finishing ahead 9.3%, which was near the higher end of our original expectations for the entire year. This strength has been driven by improved economic activity on a global basis, which in turn has produced better than expected earnings and improved confidence in the durability of the corporate profit cycle.

Our outlook for the next 12 months remains favorable, although there are challenges. We believe the economic backdrop is supportive of EPS growth of 4-6% in the next 12 months. The components, as illustrated in the chart, are real GDP +2.3%, inflation +1.8%, international GDP +0.2%, stock buybacks +2%, oil +0.5%, margins -1%, and dollar -0.5%. This produces a forward 12-month EPS base case of $133 and makes markets appear fully valued, selling at 18.3x PE.


A couple of insights on these factors. On earnings, a new accounting standard recently took effect that gives companies a tax benefit when employees exercise stock options. This helped Q1 earnings, and many strategists raised their forecasts after Q1 results were in. We did not, as we view this as a nonrecurring item.

On valuations, history shows that bull markets generally end in euphoria, with PEs exceeding 20x. While low interest rates and the earnings yield for the S&P compared to investment grade corporates and inflation remain favorable, unless animal spirits get unleashed via pro-growth stimulus measures, multiples may not rise significantly from current levels.

While a correction could occur in coming months, potentially triggered by concerns over monetary and fiscal policy actions or geopolitical/exogenous shocks, we believe the moderately favorable longer environment for GDP, inflation, and interest rates is likely to keep the secular bull market moving forward.

However, overall, we believe that expected returns looking ahead are likely to be more in line with 4-6% earnings growth than the very strong returns expected this year.

Keep Reading: Yield Curve Signaling Fewer Rate Hikes Expected

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