Who Cares About Earnings? Have companies’ profits totally disconnected from the prices of their stocks?
FactSet’s senior earnings analyst recently calculated that S&P earnings are on track to report a 14.5% year-over-year decline for the first quarter. The COVID-19 shock truly began to be felt only in the latter part of that period, so it is hard to imagine anything but worse results for the second quarter, 100% of which will be affected by the pandemic. Seemingly in defiance of this bleak earnings outlook, the S&P 500’s value has soared by 26% since its low point on March 23.
In reality, there is no factual basis for expecting earnings and stock prices to move in lockstep. Wall Street’s intense focus on EPS forecasts makes it easy to forget that the market values earnings very differently in some periods than in others. When earnings start to flatline, the permabulls reflexively begin talking about multiple expansion. The phrase “multiple contraction” is invoked far less frequently.
Earnings multiples vary over time because numerous non-earnings factors influence stock valuations. Among these is the varying energy with which the Fed pumps credit into the system, the level of merger & acquisition activity, the amount of foreign capital seeking the safety of U.S. assets, and the volume of corporate stock buybacks.
Because corporate earnings are affected by the overall performance of the economy, it is also easy to fall into the trap of thinking something must be out of whack if stock prices fail to show a consistent relationship with GDP. The historical record justifies no such conclusion. For example, over the past decade annual GDP gains averaged 2.3%. That was disappointingly lower than the 3.2% average to which Americans had grown accustomed in the previous 50 years. From 2001 through 2010, however, the S&P 500’s value rose at a rate of 11.2% a year, far exceeding the 6.0% rate of the previous half-century.
In short, history tells us there is nothing anomalous about stock prices escalating rapidly as the country plunges into recession, with severely adverse consequences for earnings. The S&P 500’s recent rise may turn out to be just a bullish interlude within a protracted bear market. Such events are by no means rare. Recent analysis by Bloomberg’s Sam Potter and Eddie van der Walt identified 20 surges of 15% or more during the 20 bear markets (defined by drops of 20% or more from the previous peak) that have occurred since 1927.
If the latest runup does turn out to be another bear market rally, the ride back down could be harrowing, judging by past experience. Between November 20, 2008 and January 2, 2009, the S&P 500 soared by 24%. From that point through March 9, 2009, stocks gave back that entire gain and more, falling by 27%. The S&P 500 then began its long climb back, but it took four more years, until March 28, 2013, for the index to reach its previous high, set on October 9, 2007. Lest anyone dismiss this as an extreme result produced by the most severe economic downturn since the Great Depression, consider a bear market rally that occurred during the comparatively mild recession of 2001. Between April 4 and May 21, 2001, the S&P 500 jumped by 19%. Over the next four months the index dropped by 26%. It was more than five-and-a-half years later— May 31, 2007—when the S&P 500 finally returned to its March 24, 2000 peak.
Clearly, stock prices can undergo violent swings both up and down without regard to the near-term earnings outlook. The case for regarding the recent, explosive advance as more than a dead cat bounce depends on believing in a V-shaped recovery from the present economic slump as early as the second half of 2020. There is no shortage of discussion of that subject on cable news. Investors, though, should know just how much is at stake when they take a side in that debate.