Champagne-Popping Returns May Let the Froth Out of the Markets

(Bloomberg) -- If fund managers had bought a basket of stocks closely resembling the S&P 500 and had played chess all through 2021 -- if only to resist the temptation to churn their portfolios incessantly -- they would perhaps have won bragging rights in their board rooms. Next year, we are told, they would like to rinse and repeat. 

Fund managers are the most overweight they have been on U.S. stocks in seven years, according to a survey by the Bank of America. Economics 101 tells us that the expected return on equities is the sum of their dividend yield, nominal earnings growth and change in price-earnings ratios and changes from repurchase returns. 

The dividend yield on the S&P 500 has been on a downhill ride, while the P/E ratio is already at heights that may induce vertigo if you looked up the charts. Unless America Inc has an epiphany next year, it’s safe to assume that dividend payout ratios aren’t about to undergo a sea change; neither can the P/E ratio get logically any giddier (though I will admit stranger things have happened in the markets). 

Which leaves us with the reasoning that in being gung-ho about U.S. equities, fund managers are essentially betting that nominal earnings growth and share repurchases will come to the rescue yet again. On the face of it, that would seem to be a reasonable assumption. If companies are able to keep raising the sticker price on the goods and services they sell in line with inflation that is spiraling up, up and away, earnings may yet climb robustly. The only nub is what such an inflation outcome would mean for the Fed’s rate trajectory. 

Meanwhile, U.S. companies have announced plans to buy $1.06 trillion of their own shares since January, almost triple the level at this time last year. Next year, corporations will continue to be the largest source of U.S. equity demand, according to Goldman Sachs -- meaning the expected percentage change in the number of shares outstanding won’t be huge. 

This year, stocks had to merely contend with noise and yet more noise from a Fed that was intent on teeing up taper. Next year, however, equities may have to brace for actual action: as things stand, we may see the end of bond purchases (please open the windows for a gust of fresh air) and the monetary authority may raise its benchmark once or possibly twice. Given that scenario, it may be safe to assume that returns on the S&P will fall somewhere between optimism and reality.

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