Equity markets around the world have rallied sharply since the March low. The U.S. S&P 500 gained 27% between March 23 and April 24, reversing half of the loss since the February peak. The rally, however, means that the U.S. market is trading at a multiple of 19.0x price-to-forward earnings, the same valuation as the February high and before the full consequences of the global pandemic were fully appreciated. Elevated valuations may not be sustainable and depend largely on where the earnings finally land.
The >20% increase in the U.S. equity market is a policy driven rebound thanks to the extraordinary magnitude and speed with which officials have rolled out monetary and fiscal policies. The positive sentiment in equities as the U.S. slowly starts to ease containment measures contrasts the deterioration in the earnings outlook. To justify higher market valuations, the focus will have to shift to how successful these same officials will be at restarting the economy and sufficiently lifting the outlook for corporate earnings growth in the medium term.
During periods of natural disasters, valuation metrics like price-to-earnings (P/E) ratios can spike before returning to more normal levels. This occurs because the collapse in earnings is much larger than the decline in price, leading to a relatively smaller denominator (E) and a higher overall P/E ratio. The case today is of both rising prices and declining earnings expectations as analysts are still catching up to the magnitude of the hit to the economy and the question of when normal economic activity will resume.
Consensus expectations is for a 14% contraction in earnings per share (EPS) in the U.S. and a 23% rebound in 2021. The net increase in EPS across the two years and an EPS level which is higher in 2021 and 2019 (Exhibit 1) is a little optimistic given the expected economic contraction. For comparison, the maximum decline in earnings during the global financial crisis (GFC) was a 40% drop when the global economy contracted by 4%. So far, U.S. earnings expectations have declined 16% from their peak but the global economic downturn is forecast to be three times what was experienced during the GFC.
EXHIBIT 1: S&P 500 OPERATING EARNINGS PER SHARE
The U.S. earnings season for the first quarter is 25% complete and so far operating earnings are tracking a 17% year-over-year drop with only 65% of companies beating analysts’ earnings estimates. Unlike during the trade war when U.S. earnings managed to be ‘better than feared’ and offset the top-down macro uncertainty, the current earnings season might not show the same pattern. Investors may be prepared to look past the first quarter or even the second in terms of earnings, however, the very unknown nature of a post-COVID economy means that few companies are offering up earnings guidance to form a complete picture.
There is also the impact of the Federal Reserve in not just backstopping the market but in suppressing the discount rate by lowering the yield on government bonds and narrowing credit spreads. Reducing the discount rate applied to earnings means that the present value is higher (or discounted by less). The implication of this is that valuation metrics are likely to be higher over time rather than lower, and add to the re-rating of U.S. equities since the March low.
Rising equity valuations in periods of crisis are not unwarranted as earnings expectations decline, before slowly normalizing as the earnings outlook improves. However, the sharp re-rating of the U.S. equity market back to valuations last seen at this year’s market peak raises questions about the sustainability of these multiples to support the market.
With many companies holding back on corporate guidance, analysts face the challenge of building a clear picture of the earnings outlook. The additional uncertainty of whether officials can successfully restart the U.S. economy without suffering a relapse in the viral spread is a further complication.
Based on the expected economic decline into the middle of the year and the risk that this bleeds into the second half of the year, these factors suggest that earnings expectations have further to fall and the rally in markets driven by the rise in the P/E ratio should be treated with a degree of caution.