By John Persinos
I enjoy reading Buddhist philosophy, which provides a mental discipline that can be useful in making investment decisions. Consider Zen riddles called "koans." They're designed to dislodge stale thinking and open the door to fresh insights. Sometimes, the riddle doesn't seem to make sense.
So here's a riddle for you: With projected corporate earnings in a double-digit slump, the global economy in severe recession, a pandemic killing people, a trade war flaring anew, and American cities beset by rioting…why are stocks rallying?
The three main U.S. stock market indices closed sharply higher Tuesday, with the S&P 500 index now up more than 35% from its March low. As of this writing Wednesday morning, all three indices were extending their gains and trading in the green.
Why the disconnect between high-flying stocks and economic realities on the ground? Let's look for an answer. Below, I also steer you toward a solution.
According to numbers from FactSet, the data provider for Investing Daily, corporate earnings results are mostly in for the first quarter of the year and they certainly don't justify lofty stock prices. For Q1 2020, the blended earnings decline for the S&P 500 is -14.6%. Meanwhile, the consensus expectations for earnings this year are dismal and getting worse.
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During the first five months of calendar year (CY) 2020, analysts lowered earnings estimates for companies in the S&P 500 for the year. The CY 2020 bottom-up earnings per share (EPS) estimate plunged 28% (to $128.03 from $177.82) during this period. "Bottom-up" is an aggregation of the median 2020 EPS estimates for all the companies in the index.
The decline in the bottom-up EPS estimate recorded during the first five months of CY 2020 was far larger than the five-year average, the 10-year average, the 15-year average, and the 20-year average (see chart).
All 11 sectors have recorded a decrease in their bottom-up EPS estimate for 2020 during this window, led by the energy (-104.8%), consumer discretionary (-58.5%), and industrials (-53.2%) sectors.
And yet, thanks to the recent rally, valuations are excessively high. The forward 12-month price-to-earnings (P/E) ratio for the S&P 500 is 21.5. This P/E ratio is above the five-year average (16.8) and above the 10-year average (15.1).
Analysts predict a year-over-year decline in earnings in the second quarter (-43.1%), third quarter (-24.9%), and fourth quarter (-12.5%) of 2020.
So again, why the disconnect? Let's start with the logical reasons (which ultimately bump into limitations).
As I've written in previous articles, the stock market is not the economy. The market is forward looking and it's already looking past our current woes to focus on the expected return to growth in 2021. Yes, more that 40 million Americans are out of work, but the jobs data are inherently backward-looking.
The stock market isn't compelled to go lower because of the bad news. The market is priced where it is because of the bad news. If the situation weren't so bad right now, stock prices would be even higher. Massive stimulus from the Federal Reserve is another major factor fueling the rally.
But these arguments only go so far. Eventually the stock market will have to face the hard reality that the economy won't bounce back to pre-coronavirus levels anytime soon.
A wide swath of jobs lost during the pandemic won't be coming back. Many reduced paychecks won't be restored in full. Lots of "temporary" furloughs will turn out to be permanent. Thousands of small businesses are going bankrupt and closing their doors forever.
At the same time, analysts are in downgrade mode for corporate earnings, which makes it doubtful that earnings can recover quickly enough to support high stock prices.
Even if the economy were completely thrown open tomorrow, millions of consumers will be reluctant to pursue their customary behaviors. (I'm in no hurry to start riding on airplanes or taking the kids to theme parks.) Yes, the economy will probably bounce back in 2021, but it won't be robust enough to sustain these frothy equity valuations. Another market swoon probably awaits.
The upshot: Stick to your long-term goals. Pursue wealth-building with mental discipline, one step at a time.
Don't get carried away by irrational bullishness. There's a famous Zen koan: "What is the sound of one hand clapping?" The riddle has no answer; it defies rational thought, just as this rally seems to defy rational thought. When the markets catch up with the fundamentals, it could get ugly.
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John Persinos is the editorial director of Investing Daily. Send comments and questions to: mailbag@investingdaily.com
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