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Equity volatility over recent weeks has been historically unprecedented. Having once priced in a moderate U.S. recession, Wall Street is now trying to focus on likely better times in 2021. This note explores how challenging it may be for markets to sustain this optimism in the face of a deteriorating earnings outlook in the months ahead.
Forward earnings: how markets ‘price in’ bad news
At the end of the day, corporate earnings drive share market performance. Given this, there’s often a lot of debate over whether market prices have sufficiently priced in a good or bad short-to-medium term earnings outlook. How far ahead should markets look?
One way market analysts attempt to quantify expectations is through a focus on ‘forward earnings’. As seen in the table below, forward earnings are a weighted average of earnings for the current and following financial year – with the weight attached to this year’s earnings based on the number of months before the new year begins.
As at end-January 2020, for example, expected CY’20 and CY’21 earnings for the S&P 500 Index were 173.9 and 192.2 respectively. Given there were 11 months before 2021 began, CY’20 earnings had a weight of 11/12ths and CY’21 earnings a weight of 1/12th, producing a forward earnings estimate of 175.4. With the S&P 500 then at 3,225, this implied a price-to-forward earnings ratio of 18.4.
By end-June, earnings estimates (as at that time) for both years will be equally-weighted in the forward earnings estimate and by December 2020, forward earnings will simply equal CY’21 expected earnings at that time. If expected CY’20 and CY’21 earnings don’t drop further, forward earnings will be 156.7 by June and 171.5 by December, implying forward PE ratios – at the current S&P 500 level of 2,761 – of 17.6 and 16.1 respectively. Arguably, 16.1 is not an unreasonable PE valuation, but it allows for no further rally in the market this year and no further downgrade to earnings expectations.
How has the market performed in past recessions*?
Does the market tend to look through a recession-induced slump in earnings? Not usually, because exactly when recessions end and earnings bottom is not easy to know with confidence.
As seen in the chart below, expected earnings for both 2001 and 2002 fell notably during the 2001 U.S. recession period, with forward earnings also dragged down and not bottoming until the tail-end of the recession. All told, earnings fell by 17% in 2001 and were flat overall in 2002, with a peak-to-trough decline in forward earnings of 18%.
The still-elevated PE ratio, however, remained fairly resilient through the 2001 recession. But due to this lingering valuation overhang – and persistent earnings downgrades for 2003 which soon weakened forward earnings again – the S&P 500 kept falling until early 2003, well past the recession.
Share Market Performance during the 2001 U.S. Recession
Source: Bloomberg. Recession period in grey.
During the 2008 recession, forward earnings initially held up – as analysts were slow to revise down 2009 earnings – but expected earnings for both years were eventually scaled back significantly. All told, earnings fell by 32% in 2008 and were flat overall in 2009, with a peak-to-trough decline in forward earnings of 40%. Note the PE ratio fell through the early part of the recession, bottoming in November 2008. In this recession, however, the S&P 500 did bottom a few months before the trough in forward earnings and a few months after the trough in the PE ratio – though the overall decline in share prices was even greater than the decline in forward earnings over the whole episode due to the decline in the PE ratio.
Share Market Performance during the 2009 U.S. Recession
Source: Bloomberg. Recession period in grey.
Two take-aways from this analysis: the PE ratio has not tended to rise in the early part of recessions (i.e “look through” the slump in forward earnings), and earnings the year following a recession also tend to be dragged down notably.
Is the worst priced in for the 2020 U.S. recession?
So how are we placed in 2020?
The chart below provides the current state of play, along with some assumptions for likely recession length and earnings decline. As at 14 April, forward earnings had already fallen by 13.5% from their end-January level, reflecting downgrades to both CY’20 and CY’21 earnings. Yet at 2,846 the S&P was only down by 11.8% from end-January levels, meaning the forward PE ratio has increased from its 18.4 to 18.8! As it stands, CY’20 earnings are currently still only expected to decline by 13% on CY’19 levels, after which they are expected to bounce back by 20% in CY’21.
Sharemarket performance during the 2020 U.S. recession
Source: Bloomberg. Assumed recession period in grey.
Given the likely depth of the U.S. recession, however, further earnings downgrades seem likely. Let’s assume the recession began in March and ends in August, and by that stage expected CY’20 earnings will have fallen 35% below CY’19 levels (similar to the 2008 decline). But let’s be generous and assume a 20% bounce in CY’21 earnings will still be expected. As seen in the chart above, this would still imply a decline in forward earnings to around 120 by August, which would have the S&P 500 trading at a PE ratio of 24 at current levels!
And if CY’21 earnings are scaled back to show zero growth (as evident in the year following the past two recessions), the the PE ratio would be at 27 by August!
Bottom line: markets are counting on a strong V-shaped recovery
All up, those who argue that markets are rightly “looking through” 2020 earnings and are focusing instead on 2021 ignore the fact that 2021 earnings are likely to be downgraded significantly (in fact they already have been!)
What’s more, even for the market to hold at current levels in the face of likely further 2020 driven declines in forward earnings would imply a rise in PE valuations – from already near recent peak levels – even as we enter the early stage of a very deep recession.
Meanwhile, even if the U.S. infection curve flattens soon, there will remain the lingering risk of a second wave until such time as a vaccine or better drug treatments are available. As a result, it’s likely that social distancing restrictions will be removed only gradually, and both business and consumers will face the risk that these restrictions could be re-imposed at any moment. That’s hardly a recipe for the V-shaped recovery markets are now counting on.
Of course, a lot can change – notably better efforts at containment and/or the speedy arrival of better drug treatments. Either way, I’ll be updating the above 2020 chart regularly as we navigate the coming potentially treacherous months. It is a fascinating time to be studying the market!
*As dated by the National Bureau of Economic Research (NBER)