Goldman Sachs just raised their year-end 2021 price target for the S&P 500 index to 4,300. That implies a 20% gain over the next year or so. The call got a lot of attention, perhaps unsurprisingly, as they expect an above-consensus profit figure for the index next year of $175 (current consensus calls for $165). Just as bullish, they expect stocks can fetch 22 times forward 12-month profits (estimated at $195 for 2022), which is where the 4.300 figure comes from.

There is a lot to unpack here. At first blush, both the valuation multiple and the profit estimate appear wildly optimistic. Predicting $175 of S&P profits in 2021, when 2019 was a record-breaking year registering just $157 seems a bit silly to me at this point. Historically, it takes more than 1 year for corporate profits to fully recover from recessionary declines (e.g. 3 years for the dot-com bubble and 2 years for the financial crisis). The pandemic seems severe enough that a shorter than average recovery might not be in the cards. Personally, I would be very surprised if corporate profits in 2021 surpassed those earned in 2019 (2022 would be a far more convincing thesis).

The other issue here is assuming a forward P/E ratio of 22 times, assigned to record-high profits. I understand interest rates are at record-lows, but if the economy really does recover swiftly in 2021, the 10-year bond rate will almost certainly rise from the current sub-1% level. If we return to 2% on the 10-year bond (where we ended 2019), there should be some downward pressure on valuations.

Stocks rarely trade for 22 times forward profits. Between 2010 and 2019, during which the 10-year bond hovered in the 2-3% range, the S&P 500 ended each calendar year at an average of 16 times forward profits, with the range being 13x-20x. In fact, I have data going all the way back to 1960 and the only time the S&P 500 has traded for 22x forward profits or more, during an economic expansion, was the dot-com bubble of the late 1990s.

If I was a strategist who was tasked with publishing S&P 500 targets (thank goodness I’m not), and I felt pretty bullish about where things were headed, I might be willing to project a 20x forward P/E. As far as profits go, let’s say 2021 matches 2019 and 2022 brings a profit increase that is double the historical average (12% instead of 6%) to account for pent-up demand from the pandemic. In that scenario, 2022 profits would be $176 and the S&P 500 at year-end 2021 would be quoted at 3,520.

I know what you are thinking; the S&P 500 is already trading at 3,560 today! See the issue? The market right now is pricing in a very optimistic outlook for the impending recovery. Put another way, for stocks to register above-average gains over the next 1-2 years (as Goldman is predicting), corporate profits need to show stunning gains and blow through 2019 levels by a wide margin.

Is that scenario completely out of the question? Of course not. Would I have a high degree of confidence at this point that such an outcome is the most likely? Not at all. Unfortunately, the market being near all-time highs now, before the economic recovery has really begun, means that a lot of good news is already priced into equity prices. Of course, markets are supposed to be forward-looking, so this is not surprising. But it should, and usually does, impact future returns.