“Are You Feeling…Lucky?”
The stock market is celebrating our triumph over COVID-19. I still feel queasy.
April 20, 2020
There is an old adage “don’t fight the Fed.” Never has that proven more accurate than in the stock market reaction to the “whatever it takes” response to Covid-19. The market rebound from the March lows is a triumph of government intervention in times of crisis. The Fed “put” is alive and well.
When the Fed pumps trillions into the system, it has to go somewhere. Would it go into bonds? Not at ZIRP. Does it go into employment? Given the stats on that, it doesn’t seem to. Does it go into infrastructure projects? There’s not a lot of roadwork being done where I live. So there aren’t a lot of places for it to go and the market goes up.
As I wrote in “How to Invest in the Time of Coronavirus” on April 2, the market is a combination of earnings and how those earnings are valued. I said that we are in a bear market, and the bear market won’t be over until earnings estimates stop their downward revision path. Since I wrote that article, the S&P500 is up 12%. Huh?
Earnings have been getting revised down, yet the market has rebounded as investors are putting a higher multiple on those earnings. The biggest economic hit to the world since WWII has only pushed the market down 16% from its high. We are celebrating our collective triumph over the virus. It could be possible that this will be the shortest bear market in history.
But I don’t think so. I think we are setting up for another leg down. Why? Earnings estimates are too high.
We are still in a negative revisions trend for 2020. On a bottom-up basis, looking at the company by a company build-up of the market forecast, there is more volatility around forecasts. As of this writing, 47 of the S&P500 companies have reported earnings. Of those 9 gave forward guidance last time. This season only 3 have. The current pattern is for companies to withdraw guidance. Experience tells us that, in the absence of guidance, sell-side analysts are overly optimistic in their forecasts. I was certainly guilty of that in my career as a sell-side analyst, and I noted it in my subsequent career as a manager of sell-side analysts.
Why do we even care about 2020 earnings? Many observers just write it off. It’s a disaster year, and people will look through it to 2021, so maybe we should pay more attention to 2021 than in 2020. Agreed. But the market is not…not looking at 2021, that is. Or at least not hard enough.
I think 2021 estimates are too high. That is an easy call to make, as out year estimates are almost always optimistic and tend to get revised downward over the course of a year. But right now, I think the situation is more pronounced than usual. I don’t see a lot of work from the street in 2021 that has any substance to it.
There is a myriad of outstanding questions about how the COVID-19 situation gets resolved. Right now we are fighting a war, and we will eventually beat the virus with the flattening of the curve, new treatments, and ultimately, a vaccine. But who is planning on how we will manage the subsequent peace
What happens when the government money machine tapers off? What happens when we try to figure out how to pay for all of this? What happens when we realize that the problems that faced us before COVID-19 haven’t gone away, indeed, they have been exacerbated? Problems like great power competition, climate change, income inequality, government deficits, etc., etc. And that we have fewer resources left to address these issues?
How are analysts going to come up with 2021 projections? Usually, they extrapolate the current year trend and tweak it a bit to be above or below the consensus depending on their bias. That won’t work this time. Maybe they fall back on “normalized” earnings, looking back at non-COVID years. That may be more appropriate, but doesn’t factor in how the cost of COVID-19 response will impact the future. Eventually, the analysts are going to have to do some real work on 2021, work that reflects the impact on the earnings power of the economy of shifting so much wealth from the balance sheet to the income statement.
In the near- to medium-term (from now to the end of the year), what can we reasonably expect?
There are many things that will make the valuation of earnings volatile. News regarding COVID-19, particularly on the “return to normalcy” and an end to the lockdowns, or a treatment or a vaccine or more testing will push the market up. As we are over the hump, that positive news flow seems to be gaining momentum and could dominate the remainder of April.
And there are other things going on that can continue to prop up the valuation of those earnings. Interest rates are likely to remain low. This aids liquidity. Those who can still afford to pay their mortgage should be able to refinance. Oil prices are near rock bottom, which, when we resume using oil, is like a tax cut.
Yet, on the earnings front, revisions will likely remain in a negative trend, at least through this month, and probably through the next earnings season in July. The Congress is pumping fiscal policy into the breach with the Payroll Protection Plan, but that all goes to payroll — there is no earnings power in it. The IRS is handing out “Trump” checks, but that just goes to keep people current on their credit card bills.
We will likely get more negative news flow on earnings during the remainder of this current earnings season, but investors seem to be minimizing that as they look through 2020. Other negative news flow, potentially about ending the lockdown too early and a recurrence of infections would likely send the market down, but we probably won’t hear too much about that until we are two weeks (the incubation period) past the end of lock-downs (most state orders expire either April 30 or May 15). As we look into the summer, news about the election could add to volatility.
In the “normal” cycle, analysts start to “roll” their projection outlooks from the current year to the out-year sometime in the third quarter. Maybe that is why so many market corrections occur in “hurricane” season (August through October).
My best guess is that July earnings season (the bet big reporting period for public companies) will be when reality about the longer-term earnings outlook starts to set in. Until then, I feel lucky…to be in cash.
