Why an increase in S&P 500 estimates is putting the market in a 'straight jacket'

Deutsche Bank Chief Global Strategist Binky Chadha joins Yahoo Finance to discuss the effects of the Fed's decision on the market, prediction on market pullback estimates, and the trajectory of earnings growth.

Video transcript

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BRIAN SOZZI: The Fed meeting's outcome has traders feeling pretty good this morning. But that could prove short-lived, given a host of major challenges facing the markets in coming days and coming months. Binky Chadha is the chief global strategist for Deutsche Bank and joins us now.

Binky, always good to see you here. Seeing the markets rally or continue their rally in the pre-market here after the Fed meeting. But I know you've been calling for a deep correction in markets. Do you think the conditions are still in place for that?

BINKY CHADHA: Yeah. The points that I would make are, the broader question is we just had a pullback. And was that what we were basically looking for? And what I would say is, if you look on a daily close basis, we closed down basically from peak to the trough 4%. I would point out that historically, the S&P 500 tends to pull back by 3% to 5% every two to three months. So I would say this was very much a garden variety pullback rather than the kind of pullback that we have been and we continue basically to look for.

That call is based on the view that growth is peaking. Typically, coming out of a recession, the early stages of a recovery, as perceptions that growth rates are peaking, the market has tended to correct by an average of know 8 and 1/2. So our call is for a more significant pullback.

And I would point out that the pullback that we just had, it's important to keep in mind that basically over the prior three months, we've had a 2% pullback in the middle of every month centered around basically the third Friday, around the options expiration.

And it just so happens that we had a couple of negative catalysts at sort of precisely that time. And so we got something a little bit bigger. But I would argue, no, it doesn't really check the box for a market coming to grips with the fact that the cycle is pretty advanced. And so we are really on the other side, yeah.

JULIE HYMAN: Binky, it's Julie here. Maybe on the other side of the cycle. But as I read your note, I wouldn't call you pessimistic certainly, for the pace of growth from here. So if we do get a deeper correction in the next couple of months here, would you come in and buy as we see stocks fall?

BINKY CHADHA: The short answer is yes. But it's really a function of how deep is the correction and what that does to positioning and sentiment. So I'm not in the camp that says, yes, we're constructive on growth, but you should therefore basically buy regardless.

And the reasons are really valuation. I mean, if you look, we had a piece out looking at a deep dive at basically equity valuations. And what I would argue is that, on any metric out there, equities are very, very expensive now.

I think we've had this discussion about equity valuations. And it was much more relaxed about that earlier in the year. It's just that the markets really continued to go wild basically. The cycle has continued to advance, at least as far as earnings and the S&P activity levels are concerned. It is much, much more advanced.

I mean, if you think about earnings, we had the big collapse in Q2 of last year. By Q4 of last year, we'd already recovered to trend. Today, I'd say we had 10% above trend or normalized levels. By year end, we'll be 20% above. And the market's sort of putting you a multiple on those earnings that is very, very early cycle, depths of recession type multiples, of pricing in big increases in earnings. And we think that's already basically happened.

I think that, as to whether I am optimistic or pessimistic, I think the point to make is that the S&P 500 is today, in our estimates, basically trading at 26 times normalized earnings. And that puts the market, I would argue, looking out one, three, and five years, in sort of a straightjacket.

So either the trend moves up and it's an 85-year trend or a normalized level of earnings. And I don't see any obvious reasons for why that's basically changed. Valuation is the concern.

And if one thinks about why valuations are high, I think a very interesting fact of this recovery is multiples jumped up. And if you think about the multiple on forward consensus earnings sort of jumped up the market began to price in a recovery, April and May of last year.

And that's perfectly normal for the multiple to go up there. But the multiple's gone sideways since May of last year up until today. And at 22 times, that's a high multiple. If you say that earnings are going to beat like they have by 15% or 20% a quarter, then the multiple on true earnings is about 15% to 20% lower than that. And the multiple sounds very reasonable.

The problem is that the forward multiple's still in that range going sideways. And the consensus has been upgraded massively already. And what the consensus is pricing in now is a slowing in the growth rates back to sort of normal.

And so to us, it doesn't make a lot of sense that the multiple's at 21 and a 1/2 or 22 times this morning.

EMILY MCCORMICK: Binky, this is Emily. On that topic of earnings growth going forward, costs have been going up for companies in terms of labor costs and supply chain challenges. And so far, companies have been able to pass these on, in large part because of this elevated demand. Are you worried that this demand might actually start to come down before we see some of these supply chain challenges get alleviated? And is that a risk for earnings growth, quickly, going forward?

BINKY CHADHA: Yeah. I'm less worried about the impact of costs on margins. This is a very popular and sort of recurring concern in every recovery. But what history suggests is that that impact, essentially early in the cycle, is dwarfed by, is sort of the operating leverage kick that firms get as sales growth comes back. And especially now, as you noted, demand's been very strong.

But if you think about some measure of activity for the S&P 500, you can think about S&P 500 sales or earnings if you like. And the simple point that I would make is that basically, there's a trend line of growth. And in level terms, we are way, way above that level right now. And so yes, the risk is that, because we are so elevated relative to trend levels, that activity actually slows. And that's exactly what, in our view, changes, really, the risk/reward.

I mean, we remain basically bullish on growth and the levels of activity. So I'm not saying the business cycle is immediately going to come to an end or any such thing. But we are where we are, which is well, well above trend levels. And so the risk/reward is that things actually slow for me.

I think retail sales is a very good example. I mean, it's far above trend and then mostly basically going sideways because they're just already at such elevated levels.

BRIAN SOZZI: Always good to see that growth. Binky Chadha, chief global strategist for Deutsche Bank, always good to see you. Have a great weekend.