As the calendar has closed the books on the second quarter of a very strange year, it is time for companies to begin reporting their earnings and giving investors a little more insight into their business trends and outlooks for the second half of 2020.
As this begins, let’s take a first look at what has happened during this year so far. As COVID-19 has caused a shutdown of many parts of the economy, along with unprecedented job loss, the estimate of S&P 500 earnings saw a dramatic decline. The chart below reflects the trend of the annual earnings estimate for the S&P 500 for the first 6 months of the year. The change in consensus earnings from Jan 1, 2020 to June 30, 2020 has gone down by 28.6%, which is the largest decline of any year since 2001.
The next chart below reflects the change in earnings estimates (solid blue line) with the S&P 500 change in price (dotted blue line) since the beginning of 2020. This shows that while the market has had a significant recovery in price, the earnings estimates continue to trend mostly downward. The earnings decline is reflective of the continued battle with COVID-19 and the economic impact that shutdowns, and delayed restarts, are having on the earnings of companies in the S&P 500.
As a result of the price recovery, but not an earnings recovery (yet), the valuation of the market is now quite high compared to history. The chart below reflects the valuation of the S&P 500 dating back to 2010, and it shows that valuations based on the next 12 months of earnings are trading at very expensive levels compared to the last 10 years.
Now, given earnings for 2020 are in decline, why are investors willing to pay more for stocks now than before? The answer is never certain, and is usually a mix of many things, but here are some potential reasons:
- The market is “looking past” this year and expecting a large recovery of 2021 earnings as a result of the temporary nature of the shut down and pent up demand once the US economy re-opens
- Interest rates are currently very low, which has historically correlated with higher stock valuations
As an example:
- The rate of a 10-year US treasury, as of 7/9/20, is 0.62%.
- The current dividend yield of the S&P 500 is 1.81%.
This means, unless dividends are cut dramatically (which is possible), the income generated by dividends alone should exceed the treasury yield over the next 10 years. For this, investors must accept risk, volatility, and potential loss of principal. The below chart reflects, however, that there have been very few instances of negative 10-year returns in the S&P 500 and the average return is approximately 10%.
To conclude, there is no question that fundamentals in 2020 have deteriorated and valuations are expensive relative to history. In our opinion, however, the market is reflecting a stance that earnings can recover and accelerate in the future and the risk/reward of owning stocks compared to bonds right now is favorable. This earnings season, as companies begin to discuss their business trends and outlooks, will be important to de