Stock markets are supposed to follow corporate earnings, or so the saying goes. Therefore, it’s natural for stock prices to climb to new highs when companies report stellar growth in profits.
This works the other way around as well. For instance, U.S. markets tumbled in February as investors feared disappointing financial results from companies in the coming quarters. Dr. Edward Yardeni, the president of Yardeni Research and a prominent economist, believes that corporate earnings in the United States are bottoming, which is an encouraging sign for investors. In a report recently released to the public, Yardeni wrote:
“S&P 500 forward earnings rose last week for a second week, after dropping every week since the week of March 5. We aren’t surprised since we’d been thinking that this might happen in June given how quickly and sharply consensus estimates have been slashed in recent weeks. The 2020 estimate is falling faster than the 2021 estimate, which is why forward earnings may be starting to bottom-i.e., the 2021 estimate gains more weight in the forward earnings calculation as that year approaches. Now, we are calling a bottom in forward earnings. If it continues to rise, as it has during the past two weeks, then it will have bottomed eight weeks after the market did so on March 23. That would be similar to the global financial crisis experience, when forward earnings bottomed nine weeks after the March 9, 2009 trough in the S&P 500 index price.”
In this analysis, we will go beyond the 2008 recession to determine whether market performance and corporate earnings have reacted similarly during multiple economic downturns. If this theory holds true, the next step would be to identify the best sectors to invest in.
The market is forward-looking and should be used as a leading indicator
In his report, Yardeni is emphasizing the forward-looking nature of markets. Because of this characteristic, stock prices react in advance to both positive and negative developments.
According to data from Barron’s, corporate earnings dropped by 30% during the recession of 1990-91, with the S&P 500 index bottoming two quarters before earnings did. The market performance during the dot-com bubble was similar. An evaluation of recent market moves in light of these historical characteristics paints a clearer picture of what exactly is happening today. As illustrated in the below chart, the broad market index reached a bottom on March 23, which is approximately two quarters before corporate profits are expected to reach a low.
Source: GuruFocus
The second quarter of this year is widely believed by analysts to be the most difficult period of this recession, as many businesses in the country remained closed in these three months during the lockdown. The market reaction, therefore, seems quite identical to what has happened during the last three downturns.
Economic data such as initial jobless claims and quarterly GDP growth are reported at the end of a period, which means these data reveal what has already happened in a given time period. Because markets are forward-looking and represent the future expectations for the economy, stock prices are bound to reach new lows in advance of companies reporting disappointing numbers.
The consensus Wall Street estimate for S&P 500 earnings per share in 2021 indicates a 25% increase from 2020, and this stellar growth is expected on the back of trillion-dollar stimulus packages introduced by the government and debt-favoring monetary policy measures adopted by the Federal Reserve.
Source: RBC Wealth Management
The sentiment is driven by these expectations, which is not surprising because markets are leading indicators. Understanding this relationship could go a long way in helping investors make better decisions.
The sectors to look out for
Even after the significant gains in the last couple of months, the tech sector still seems to be one of the best places to look for bargains. Many gurus, including Warren Buffett (Trades, Portfolio), are bullish on this segment of the market, which is evident from billion-dollar investments in the likes of Apple Inc. (AAPL, Financial) and Amazon.com Inc. (AMZN, Financial). The strong balance sheet position of these companies combined with the expected shift to a more technologically advanced global economy will pave the way for the largest companies representing this sector to generate a very attractive return on invested capital, which should, in return, lead to capital gains.
The beaten-down energy sector should also be closely monitored to identify investment opportunities. According to data from Eikon, this is the highest-yielding sector in the market with an average dividend yield of over 4%, and the resumption of business activities will boost crude oil prices, setting up a good platform for the industry to report better numbers in the coming quarters (for the companies that don't go bankrupt, at least).
The outlook for the banking sector is mixed. Interest rates in the country are at record-low levels, and Fed chair Jerome Powell confirmed in May that this low-rate environment will likely extend well into 2021 at the very least as supporting credit growth is one of the top priorities of the Fed. This macro-economic outlook is unfavorable for the financial services industry as net interest margins will compress under these conditions, limiting the ability of banks to expand operating profit margins.
The risk of a second crash is not completely out of the window
The global economy is slowly and steadily returning to normalcy. Many business sectors are beginning to report encouraging numbers. For instance, Business Insider reported last week that demand for crude oil in China is almost back to the levels seen in December. Other important regions such as the United States and Europe are easing travel restrictions as well, and it seems like the worst is over. However, investors should never underestimate the risk of a second market crash as reopening the economy will not be a straightforward task. For example, South Korea had to close nightclubs and restaurants just two days after permitting them to operate in the city of Seoul as a preventive measure to avoid a second wave of the pandemic in the country. This is a risk faced by all other nations as well. If this risk materializes, the market will likely tank again.
Takeaway
The market has bottomed far in advance of the worst numbers that are expected in the second quarter. While this has baffled many investors, it is important to realize that stock prices are leading indicators of expected economic developments. Empirical data suggests that the recent market performance is well and truly in line with what was experienced during the previous two recessions. While the risk of another crash is still very real, the global economy will eventually recover. Therefore, I think now is a good time to be hunting for bargains.
Disclosure: I do not own any stocks mentioned in this article.
Read more here:
- Behind Bill Ackman's Sale of Berkshire Hathaway
- Investing Lessons From the Failure of Hertz
- Boot Barn: A Retail Play for the Reopening of the Economy
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