S&P 500’s Implied Growth Falls to Cycle Median

December 18, 2018

RJ Steinhoff, CFA
Director of Research,
Portfolio Manager
We track implied growth rates for many markets around the world as part of a suite of approaches we utilize to assess overall valuation levels. Calculating implied growth is a simple but effective way to get a quick sense of growth expectations embedded in current prices. Growth expectations above cycle averages might be an indication that market participants have become too ebullient about future growth prospects. Low expectations might identify an opportunity if the consensus outlook is too pessimistic.

The implied growth calculation flips the typical valuation equation (i.e., discounting earnings or cash flows) on its head, setting the valuation at current market prices and then solving for the growth rate. In our approach, we use normalized earnings as a proxy for cash flows. Each company’s cost of equity is calculated using trailing three-year betas and the 10-year Treasury rate for the risk-free rate.

The median implied long-term earnings growth rate for the S&P 500 constituents currently stands at 3.0%, off 90 basis points from this current economic cycle’s peak of 3.9%, hit at the end of 2013 and Q2 2017. Implied growth is now 20 basis points below the cycle median of 3.2%. As shown in the annotated chart below, this current correction marks the third retreat of growth expectations since the cycle started in June 2009.

Many technology stocks like Nvidia and Microsoft have seen declines of more than 15% since September. However, implied growth for the Information Technology sector is still above the cycle median of 4.1%. The real carnage has been in the newer Communication Services sector, home to internet-focused companies like Facebook and Netflix and the traditional media and telecom players like Disney and Verizon. Implied growth has tumbled to negative 0.5%, a steep decline from the 3.5% and 4.2% seen at the end of Q1 and Q2, respectively. At 5.4%, the implied growth spread between the Information Technology and Communication Services sectors is the highest observed since this cycle started.

Financials has been another hard hit sector. Implied growth for Financials stands at 0.4%, trading at one of the biggest gaps to the overall market since 2009. Major global banks like Citigroup and Bank of America have declined on rising market volatility, evidence of slowing consumer loan activity, and a flattening yield curve.

We see the overall market, at 15x forward earnings and a median implied growth rate of 3.0%, as fairly valued. The good news is that the overvaluation seen at the peak of September/October euphoria—marked by Apple achieving a trillion dollar market cap—has been relieved. With implied growth falling back to the cycle median, compelling risk/reward opportunities are emerging, especially in the Communication Services sector.

The critical question facing investors now is whether or not the global economy is on the verge of a recession. We see growth decelerating but do not see any data points, including our own Economic Composite, pointing to a global recession. Therefore, until evidence emerges, we continue to seek out opportunities in undervalued, high quality businesses.


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