To Understand the Wild U.S. Stock Rally, Just Forget About 2020
The stats border on the ridiculous. On the eve of an earnings season nobody has a clue about, the S&P 500 notches its best week in 46 years. About $4 trillion has been added to share prices, a few weeks after $10 trillion was sheared off.
Does it make any sense? To skeptical Wall Street veterans, the answer is obvious: no. While stimulus is flowing and the curve may be flattening, investors are bidding up stocks at a time unemployment may already be 15%, with economists forecasting one of the biggest contractions ever. Only a fool buys equities trading at 40 times the worst estimates for this year’s profits.
To all that, a single rebuttal exists. That in the absence of clarity, investors have no choice but to write this year off entirely. No matter how bad the recession gets, markets look forward -- relentlessly. Whatever horrors the world is yet to endure investors will focus on the recovery.
“It’s almost as if nobody is even going to worry about 2020,” said Chris Gaffney, president of world markets at TIAA. “If the earnings are so bad that it looks like the company won’t be able to survive, that matters. But for most companies, investors have to look past 2020 because nobody knows what’s going to happen.”
To be sure, it takes a radical bull case to ignore everything going on now. Companies may be suffering lasting structural damage to their earnings power. Surely equities are worth less in a recession, objectors say, and who knows how long it will take to rebuild the economy? That’s why Wall Street has been heaping mud on the S&P 500’s 25% jump since March 23, saying it’s a bear-market bounce. But it’s the only viable way to explain a week in which the Nasdaq 100 ended just a couple big days away from erasing its 2020 decline.
While there’s no historical parallel for what’s going on today, the experience of individual companies that survived sudden blows to their profits may be relevant. It’s a deeply inexact model, prone to survivorship bias, since when faced with existential threats, many companies don’t make it. But a few examples, particularly of industrial megacaps who had profits for entire years gutted by giant fines, may hold clues for the S&P 500 should the recession prove brief.
Consider BP PLC. After the oil explorer and producer coughed up a record $20.8 billion in 2015 to pay for damages caused by an oil spill, earnings per share dropped roughly 50% for two years straight before tripling in 2017. Its stock price came back even faster. After falling 14% in 2015, shares soared 44% in 2016 for the best year since 1993.
Similarly, when Volkswagen AG was forced to set aside tens of billions of dollars for lawsuits and damages after an emissions scandal dubbed “Dieselgate,” it didn’t take long for a rebound to materialize. Shares plunged 18% in 2018, then surged 25% in 2019.
A more sobering model -- though possibly a more pertinent one -- is financial institutions in the 2008 crisis. While the collapse of Lehman Brothers Holdings Inc. is the highest profile, more than 400 banks failed by 2011, according to the Federal Deposit Insurance Corporation. But massive bail-outs helped others survive. After plummeting 50% in 2008 and seeing a fifth of its members removed, the KBW Bank Index fell less than 4% in 2009 before jumping 22% in 2010. By the end of that year, the gauge was up 180% from its lows.
“It’s a small fraction of companies that are going to go bankrupt, and the surviving companies will end up with a better competitive position,” said Chris Brightman, the chief investment officer of Newport Beach, California,-based Research Affiliates. “We saw that very clearly in the global financial crisis. Did a few banks go bankrupt? Yes. Was the entire banking system going to go bankrupt? Of course not. Did that set the remaining banks up for a fabulous run during the recovery? It absolutely did.”
Of course, the surviving companies in question above were otherwise healthy before whatever crisis struck. Solvency concerns do run high in the current environment, as no one truly knows how long global economies will remain shut due to the coronavirus, but odds are most survive, and activity will return in time. According to Bloomberg Intelligence, any 2020 economic downturn may be sharp, but short, and duration matters more than the depth for stocks.
Still, the time frame is “entirely dependent on the length of the shutdown,” wrote strategists including Gina Martin Adams.
Investors expecting to look past a quick recession may have longer to wait than they realize. Restrictions forced on the economy by virus-related measures will prolong its slump “through 2020 and much of 2021,” wrote Narayana Kocherlakota in a column for Bloomberg Opinion published Thursday. The former president of the Fed Bank of Minneapolis says the likely length of the downturn means governmental stimulus efforts need to be much more ambitious.
If history serves as a guide, a deep, yet brief recession would be rare. The average recession since World War II has lasted 11 months, according to LPL Financial, and the shortest ever was six months. The probability of a U.S. recession in the next 12 months jumped to 100% in March, a Bloomberg Economics model shows. If one began last month, then an average recession would would put the economy on track to climb out in February of 2021.
The market has a strong track record figuring out when a recession may end. Stocks bottomed an average of five months before downturns ended in 10 of the last 11 recessions, according to Luke Tilley, chief economist at Wilmington Trust Corp. and a former adviser with the Federal Reserve Bank of Philadelphia. He currently sees the U.S. economy starting to recover in the third or fourth quarter, meaning “stocks could start to price in that recovery and begin a sustainable rally relatively soon -- assuming the market has not yet bottomed,” he said.
An escape of a re-test of the stock market’s lows would be unparalleled, though, in Bank of America’s view, considering bear markets that coincide with economic downturns are strongly tied to their depth and length. The firm’s economists expect one of the deepest recessions on record, and equity strategists including Savita Subramanian see S&P 500 profits plummeting 29% this year to $115 a share.
Based on BofA’s models, it may take a few years for earnings to return to peak levels, but the snapback should be faster than usual considering quick and aggressive policy measures and a higher quality makeup of the S&P 500 as industries like software have grown more important and energy less so. During the financial crisis it took 17 quarters to recoup all lost earnings, and eight years after the Great Depression. The firm sees profits rising as much as 35% in 2021 to $155 a share.
“Markets will look through and forecast what they think are permanent impairment to earnings as opposed to short term, a couple of quarters of severe pressure on earnings,” said Matt Forrester, chief investment officer at BNY Mellon’s Lockwood Advisors. “How much damage is very up in the air, that’s why markets have had so much volatility. We’ll begin to get some assessment of that.”
©2020 Bloomberg L.P.