Resistance under pressure
The US stock market continues to function, with the S&P 500 close to positive for the year and still a surprising distance from new all-time highs. This has happened despite the start of the worst economic contraction in at least a century. As a result, US stocks are trading at a historically high premium. And in the coming weeks, stocks are about to rise much more expensive. This, along with the realities associated with the economic outlook, has important implications for the outlook for the US stock market.
Already expensive
How expensive are American stocks today? The current future price-earnings ratio on the S&P 500 based on 2020 earnings is 35.6 times earnings.
Sounds expensive already, but let’s put this assessment in an additional context.
The historical average price-to-earnings ratio for the S&P 500 dating back a century and a half ago is 15.6 times. Therefore, today’s valuation is more than + 125% higher than the historical average.
The forward P / E ratio on the S&P 500 has been higher than 35.6 only twice more in history. Both are recent episodes. The first was from 2001 Q1 to 2002 Q2 during the bursting of the technology bubble. The second was from the second quarter of 2008 to the first quarter of 2009 during the Great Financial Crisis.
During these past two episodes, the P / E ratio moved more than 35 times future earnings, because while the price of the S&P 500 was falling (the “P” in the P / E ratio), the gains were falling much faster (the “E” in the P / E ratio). In contrast, the P / E ratio has moved more than 35 times the gains advanced today because the price of the S&P 500 is growing even though the profits are falling significantly.
How much have the profits fallen?
The earnings outlook was positive not too long ago. On February 21, 2020, when we first learned that COVID-19 had officially spread beyond China to countries like South Korea, Iran, and Italy, corporate GAAP earnings in the S&P 500 were forecast to be in the $ 35 range. and $ 43 for sharing.
Almost five months later and completely in the depths of COVID-19 on July 8, 2020, we see the following revisions to the GAAP earnings forecast.
It’s worth noting that 2020 Q1 is already on the books, and the final number was -67% below the February 21 forecast at $ 11.88 a share in the S&P 500. In other words, we saw that two-thirds came out. Q1 number just as economies began to close in the last two weeks of the quarter in mid or late March.
The second quarter 2020 earnings season has just started
While the previous forecast for the second quarter has already been revised down to just over half from $ 38.92 to $ 19.15, it is likely to drop considerably more in the coming weeks. Why? If shutting down parts of the US economy for a couple of weeks in late March reduced two-thirds of the Q1 number, it is highly likely that the majority of the US economy is under orders to “stay in home “for at least two months of the quarter, if not more, will eliminate most, if not all, second-quarter earnings. As a result, don’t be surprised if we see a negative impression of GAAP earnings for the second quarter of 2020 before everything is said and done.
What about 2020 Q3 and Q4?
These GAAP earnings forecast readings are likely to remain overly optimistic. Why? While these readings have been revised downward for Q3 and Q4 by -35% and -25%, respectively, they continue to project essentially a “V-shaped” recovery with gains returning to pre-COVID-19 levels at a fairly fast pace. But given the virus’s renewed upward trajectory this summer, a much more challenging economic and corporate earnings environment is likely to persist for much of the rest of 2020, if not more.
By many estimates, summer was supposed to provide a pleasant break in new daily virus cases before a second wave resurgence in fall and winter. Therefore, the fact that the first wave actually never ended and the virus is emerging this summer is very puzzling not only because of the economic and market prospects, but also because of the health outlook for the US. the weather becomes colder in the coming months.
Tipping the shark
As a result, my previous moderately upward sloping “shark tooth” economic recovery projection from a few weeks ago may turn out to be a flatter to downward sloping “shark tooth” routine as the US economy. and expanding throughout the country in 2020 Q3 and Q4. This implies corporate earnings that may end up being a small fraction of current estimates by the time the final numbers are reported through the end of 2020 and through 2021.
To be prepared
If United States equities are truly a forward-looking mechanism, investors should be preparing their portfolios now for much weaker economic and corporate earnings than is currently projected. For example, it’s more than conceivable that we could see an S / P 500 P / E ratio pushing north 100 times earnings based on its current price of $ 3,215 as of July 16. And unlike the only other time we saw such unusual multiples in the S&P 500 during the depths of the GFC in 2008, we are unlikely to see a relatively quick rebound in corporate earnings this time.
Many have spoken of the 90% economy following the COVID-19 crisis. Given the ongoing struggles to deal with the virus in the US, we may see something more akin to an 85% or 80% or less economy going forward. This, together with the possibility of persisting profit margin reduction forces, such as the shortage of inputs, periodic interruptions of production and changes towards deglobalization, among other factors, has the potential to keep corporate profits covered during the next quarters, if not the next years or more.
And even if US stocks are no longer the forward-looking mechanism they used to be, stocks with a constantly varying earnings yield of less than 1-3% will spell the likely end of TINA’s trade (“There is no alternative “), as there will be a number of more attractive alternatives to the shares available in these valuations that do not include the equity risk and default risk that comes with holding stocks.
These scenarios suggest the increasing likelihood that US stocks will fall in the coming months, potentially in a significant and sustainable way. And this may be true regardless of the amount of monetary liquidity that the US Federal Reserve pours into this market. For all asset purchases in the world, asset prices can increase, but they will not generate income and they will not generate profits. And at some point, recipients of the Federal Reserve’s ongoing generosity are likely to divert this liquidity to other assets to provide a more attractive expected risk-adjusted return.
After years of political stimulus, stocks have fallen from record levels and bond yields are at record lows. Reality is increasingly turning to world capital markets. Do you have a plan to navigate what’s left of the current bull market while positioning yourself for the next bear market?
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Divulge: I / we have no positions in any mentioned action, and we have no plans to initiate any positions within the next 72 hours. I wrote this article myself and express my own opinions. I receive no compensation for it (other than Seeking Alpha). I have no business relationship with any company whose shares are mentioned in this article.
Additional disclosure: I have long selected individual stocks as part of a comprehensive asset allocation strategy.
Disclosure: This article is for informational purposes only. There are risks related to the investment, including loss of capital. Gerring Capital Partners and Global Macro Research make no express or implied warranty regarding the performance or result of any investment or projection made. There is no guarantee that the objectives of the strategies discussed by Gerring Capital Partners and Global Macro Research will be met.
