Don’t Think About 2020 Is Valuation Mantra for S&P 500’s Big Run

(Bloomberg) -- At the end of the calmest week in two months for the S&P 500, it has gotten a little easier to see how stock bulls are thinking about the market’s valuation. More than ever it involves looking past this year.

Perched around 2,800, the benchmark trades for 21 times analysts’ best guess for 2020 earnings, a multiple at the highest end of the historical range. Look a little further out, though, and things settle down. Relative to 2021 forecasts, the forward price-earnings ratio falls to 17, very close to its historical average over the last half century.

It’s one of the many peculiarities of the coronavirus era, that faced with a choice between endless uncertainty and the belief a recovery will one day take hold, investors are casting their fate with the latter. While skeptics ask how anyone can write off a year like this one, bulls pin their hopes on prospects the recession will be temporary.

“The market isn’t concerned with this year’s earnings,” said Andrew Slimmon, senior portfolio manager at Morgan Stanley Investment Management. “We are going to start to see the market base itself off of next year’s earnings projections, because these are where we can draw conclusions about a company’s true long-term valuation.”

Forecasting profits and the trajectory of the economy has arguably never been harder. Companies don’t know what to say. A quarter of S&P 500 firms have withdrawn at least part of their full-year guidance, according to Wells Fargo Securities. Even that is sitting reasonably well with investors who, based on the size of daily moves, have guided stocks to the most tranquil week since mid-February.

After slashing their estimates again this week, analysts now expect S&P 500 companies to generate earnings of $133.10 a share in 2020, Bloomberg Intelligence data show. That leaves the index trading at 21 times those expectations, higher than at the market peak in February.

Forget 2020 and pin your hopes on next year’s projected profits of $164.70, though, and the price paid for stocks at these levels comes very close to the average since 1970.

With that in mind, Brian Belski, chief investment strategist at BMO Capital Markets, says the stock market not only bottomed on March 23, but also that investors shouldn’t be surprised if the rally ultimately reaches as much as 50% from those levels. He’s focusing on what he calls “the triple whammy facing stocks” -- a 22-day cyclical bear market, an earnings recession, and an economic recession -- and what that means for equity prices further out in the future.

“So much has been made of analyzing the curve of the virus; our recommendation is that investors need to do the same with earnings,” Belski wrote to clients. “When we do this and focus less on the actual number for first and second quarter EPS for the stock market, we see that trailing 12-month earnings trends are following the traditional script.”

While bears squawk, history is replete with instances of the market rallying when earnings were in the tank. In fact, over the last seven decades, there was only one instance when profits rebounded before stock prices, according to data from Minneapolis-based Leuthold Group. Take the financial crisis, for example. After the S&P 500 bottomed in March 2009, the benchmark gained 67% by the end of the year, yet earnings came in 30% lower.

All this is a lesson in why it might not pay to take the current earnings season overly seriously, as least as far as equities are concerned. First-day reactions in the market to results relative to analyst estimates were bigger than usual last week. This week they’re smaller than usual, according to Credit Suisse.

To be sure, while investors may be taking comfort in an expected profit comeback in 2021, nothing is certain. As forecasts stand, analysts see profits rebounding close to 24% next year after a 19% contraction in 2020.

Lori Calvasina, head of U.S. equity strategy at RBC Capital Markets, says it’s possible that this year’s estimates have been cut enough, but she’s more skeptical on next year’s numbers. As it stands, S&P 500 companies are expected to generate just as much profits in 2021 than they did in 2019, when earnings totaled $165 a share.

“We are concerned 2021 numbers now need to be cut more aggressively,” said Calvasina. “In recent earnings calls, several companies have alluded to the idea that the economic recovery will be slow or uneven, and that it may take considerable time for the US economy to get back to pre-coronavirus levels.”

The uncertainty leaves investors in a bind. Michael O’Rourke, chief market strategist at JonesTrading, suggests using a more normalized earnings forecast that looks beyond any recession. However, factors including what personal and corporate tax rates will look like and fewer share buybacks should be taken into account, likely meaning 2019 will represent peak profits for several years.

“Investors should be and are writing off 2020 earnings,” he said. “The current environment is not indicative of corporate earnings power. That said, investors can’t truly be looking at 2021, because nobody, not even the companies, have an idea as to what the environment will be.”

©2020 Bloomberg L.P.