The Valuation Recovery
The S&P 500 rose by 4% in May, which means a 17% increase in value over the past two months. That large of an increase in light of the economic hardship many businesses and individuals are facing is causing some investors and analysts to question the rationality of current market valuations.
In having many conversations over the past couple of months with our investment committee, investment managers from many firms, and many of our clients, there seems to be a strong understanding of the wide variety of potential outcomes, but some questions of what current valuations imply about the likelihood of those outcomes. Those questions come in three forms – the impact of economic indicators on stock prices, the magnitude of the overall decline in valuations, and the differential between near-term and long-term effects on profits.
In theory, and in practice, the valuation of an individual company is primarily based on the future earnings that company will generate. The overall value of a market index such as the S&P 500 is the aggregated value of the individual companies, so its value is based on the aggregated future earnings of the component companies. The pandemic has deep effects on nearly all aspects of life but will only impact the valuation of stocks to the extent they directly or indirectly affect earnings.
In normal times, a healthy economy and a healthy stock market are often synonymous. We tend to think that low inflation, low unemployment, and high economic growth are important factors driving the stock market. But that’s not always the case. In the mid 1980’s, the stock market enjoyed outstanding performance despite a relatively high inflation rate. The past decade also experienced high stock market returns despite tepid economic growth. And we know improvements in technology can cause stock market increases despite a negative impact on unemployment. Specifically, broad economic indicators are good for the stock market if, and only if, those factors show up in corporate profits.
Hence, despite the relatively high unemployment, and the certainty that we are currently in a recession (not officially, but we know what the lagged economic statistics will be), it is possible for the stock market to rise because of the outlook on corporate profits. In economic downturns, the stock market is a leading indicator of economic recovery. Yes, the unemployment rate is staggering and will remain high for quite some time, and thousands of small businesses will be irreversibly harmed by the pandemic, but the factor that affects the stock market is corporate profits.
Magnitude of the decline
Now that the worst of the market decline is two months behind us, many seem to have forgotten how bad it was. Between February 19 and March 23, the S&P 500 fell by 34%. The past couple of months have lessened the damage, but the market is still 10% lower than it was before the crisis began three months ago.
Such a decline over three months has only happened one other time (late 2018) in the past 10 years. Even after the partial stock market recovery, there is still a large loss in value, which reflects the lost profitability for this year and next.
Timing of Earnings
Earnings for the first quarter fell by 50% compared to the last quarter of 2019. However, over the next seven quarters, corporate earnings are forecasted by analysts to monotonically grow at a rate of 12% per quarter (an annual compounded rate of 60%). Some of that earnings growth is a result of government stimulus. Those earnings forecasts suggest a nearly full recovery by mid-year 2021, although most predictions for GDP have a longer recovery time. Comparing current valuations to last quarter’s earnings, or even forward looking one-year earnings, is irrelevant because of the forecasted earnings growth.
Only about 10% of the value of a typical stock is based directly on earnings over the next two years – the remaining 90% is based on the longer-term earnings in perpetuity. And while there certainly will be some permanent impacts to some companies caused by lifestyle changes, in the aggregate, that value is largely unaffected by the current pandemic.
What is the Correct Value?
No one knows for sure. In analyzing the earnings forecasts, we can certainly justify the current level of valuations. There is still much uncertainty, and as we learn more about how quickly the economy can safely begin to open up, we will see rises and falls in value. A portfolio with long-term objectives should continue to have a large allocation in stocks.
Chart data source: Yahoo