The U.S. economy shrank at a 4.8% annual rate last quarter as the coronavirus pandemic shut down most of the country and triggered a recession, but analysts feel the second quarter will be much worse. (April 29)
The economy just contracted 4.8% in the first quarter, and an even worse number lies ahead for the second quarter.
Yet the stock market has been rising formost of the past five weeks, notwithstanding a sharp drop late last week. What gives?
Clearly, investors have been reacting positively to the massive stimulus measures adopted in Washington and expect things to improve, perhaps dramatically, later in the year. They also hope coronavirus infections start to ebb and the economy can be opened fairly soon.
But they also might be doing something else — ignoring earnings reports, dividend cuts, layoffs and all the other announcements that normally would be scrutinized closely. Given the health emergency and economy-shackling measures that have made this such an unusual period, it might be wise to take a break from doing your usual financial homework as it pertains to analyzing specific stocks.
Quantifying the impact difficult
If there were a time to tune out much of the investment noise, this is it. Earnings reports in particular just don’t seem all that relevant now, given all the uncertainty out there.
“We are in uncharted territory with respect to the economic and corporate-earnings impact of the ongoing lockdown environment,” wrote Sheraz Mian, director of research at Zacks Investment Research, in a commentary on quarterly earnings reports that are now rolling out. “The level of uncertainty about the extent and duration of the underlying public-health issue makes quantifying the impact very difficult, if not altogether impossible.”
There certainly are good reasons not to pay too much attention to the bleak numbers. First-quarter net income for the roughly 200 companies in the Standard & Poor’s 500 index that have reported so far are showing profit drops of 17% on average on flat revenue, according to Zacks.
For all of 2020, in general, analysts who follow S&P 500 companies expect their profits to tumble almost 20% on average, as revenues contract about 7%, according to Zacks.
Looking at those sort of numbers in isolation, few people would want to stick a toe in the stock market, yet turning away now could be a mistake.
Focus on financial stability
But if earnings aren’t as important at the moment as they normally are, what is? Factors that reflect a company’s financial strength, or lack thereof, could gain prominence.
Announcements of dividend cuts and even share-buyback suspensions are troubling, as they signal a scarcity of cash or looming problems ahead. Yet more corporations are taking these actions amid all the coronavirus uncertainty.
Dividend payments by companies in the S&P 500 index reached a record $127 billion during the first quarter, but Howard Silverblatt, a senior analyst at S&P Dow Jones Indices, doesn’t see the trend continuing.
“For 2020, liquidity and cost control are now the top priorities, with dividends lower and buybacks an endangered species,” he wrote in a recent commentary.
Companies that have cut or suspended their dividends include Boeing, Ford Motor, Delta Air Lines and Freeport-McMoRan, the Phoenix-based copper giant.
Maintaining a dividend and keeping a lid on costs are important. So is a company’s ability to manage debt, perhaps even overshadowing the current profit and revenue trends. Many investors seem to be banking on a sharp rebound once the worst of the virus news has passed, but there’s still the possibility of a prolonged recovery in a series of fits and starts.
“The longer this goes on, the more investors must consider the survivability of a company,” said Trevor Wilde, managing director of Wilde Wealth Management Group in Scottsdale. That brings aspects like a company’s debt load, ability to raise more capital if necessary and changes in the company’s bond ratings into perspective, he said.
“People are expecting a V- or U-shaped recovery, but what if they’re wrong?” Wilde asked. “Then survivability and balance-sheet strength become more important.”
Explaining the rally
All the turmoil of late and the prospect of further bad news have left some investors wondering why the stock market has been rallying in recent weeks, especially as the earnings picture now looks so bleak.
“Given that the global economy has essentially ground to a halt due to COVID-19, it may seem surprising that (the stock market) is not down more,” wrote David Kelly, chief global strategist at JPMorgan Funds, in a mid-April commentary when the S&P 500 was down about 18% from its February peak. “There are, however, some logical reasons for the stock market not to overreact.”
One reason cited by Kelly is that many of the sectors most impacted by the coronavirus outbreak, such as real estate, energy and discretionary consumer products, account for relatively small slices of the stock market compared to, say, technology, financial, health care and utility companies.
A second reason is that with interest rates having dropped so much lately, “stocks look a lot more attractive” compared with alternatives in the bond market and elsewhere, he continued.
Focus on long haul
The third reason, involving corporate profit streams over time, isn’t so obvious. Even as already depressed earnings come in below expectations, “Investors need to appreciate just how much stock prices depend on long-term earnings,” Kelly argued.
For example, stocks in the S&P 500 index on average currently sell at a price of about 20 times this year’s expected earnings. In other words, a P/E ratio of 20 is another way of saying this year’s earnings account for 1/20th of the price of the average stock. All the remaining value depends on earnings that won’t be generated for more than a year into the future, Kelly noted.
Under many forecasts, 2020 will go down as an awful year owing to coronavirus disruptions, yet that could be followed by a much better environment down the road. With a longer-term view, the relatively muted stock-market slump to date doesn’t seem so odd, he said, despite all the craziness and near-term profit malaise out there.
Reach Wiles at [email protected] or 602-444-8616.
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