June 24, 2020

Key Takeaways:

  • The near-term earnings and valuation picture is filled with uncertainty; however, earnings trends appear to be turning the corner after cuts reached the most extreme level since 2009.
  • Looking under the hood of the market and analyzing the sectors provides additional insight to the earnings story. The majority of the growth and defensive sectors are expected to recapture their 2019 earnings level by 2021, while estimates suggest it will take until 2022 for most cyclical sectors.
  • Based on 2021 estimates, most sectors are trading near the same price-to-earnings (P/E) ratios reached at the end of 2019, prior to the coronavirus shock, with energy and consumer discretionary being the only two sectors well above those levels.
  • On a 12-month outlook, we retain an equity bias (with a modest growth tilt) relative to fixed income and cash, even while we continue to expect markets to remain choppy near term as stocks digest the strong gains from the March low. 

The near-term earnings and valuation picture is filled with uncertainty given the ongoing pandemic and its effect on the global economy. The potential earnings range is so wide that any estimate should be viewed as more of a starting point as opposed to a precise number. Given this backdrop, we are much more focused on the progression of forward earnings trends, among other factors, within our work.

Following the coronavirus shock, analysts aggressively cut earnings estimates as the economy largely went on lockdown, and the US entered a recession. At the worst point, the S&P 500’s forward 12-month earnings estimates were cut by 14% and 20%, on a one- and three-month basis, respectively. This is on par with what occurred at the worst point of the financial crisis in 2009. However, like then, these reductions have reached a negative extreme, and the worst of the cuts now appear to be behind us.

Indeed, the S&P 500’s forward 12-month earnings estimates stabilized in early May and since then have gradually risen. This is a similar pattern to what occurred in 2009. That is, stocks bottomed before the earnings improvement was evident, which took place a few months later.
A similar picture of stabilization is apparent when looking at the individual 2020 and 2021 calendar-year earnings trends.
The market is largely looking at 2020 as a one-time, write-off year, with the focus squarely on 2021. The bottom-up earnings estimate for the S&P 500 in 2021 is $163, which is where profits peaked in 2019. This estimate is aggressive. Historically, on a 12-month basis, once actual earnings trough, it has taken a little over two years, on average, for earnings to recapture their former peak. That said, the current decline in profits has been quite unusual as the economy was on a forced lockdown. Much of the earnings path forward will be dependent on the success of a vaccine and/or therapeutics as well as the corresponding path of the coronavirus and the economy.

A Story of Sectors

Looking under the hood of the market and analyzing the sectors provides additional insight to the earnings story. What we find is a picture of wide dispersion. Most of the growth and defensive sectors—which comprise a significant part of the overall market—have held up very well this year and are expected to recapture their 2019 earnings level quickly. For example, the earnings of technology and health care, which represent about 40% of the S&P 500’s overall sector weights, are estimated to see earnings above the pre-coronavirus levels by 2021 (technology is on track to do so this year) as are communications, staples and utilities.

Conversely, economically-sensitive sectors, including industrials, consumer discretionary, financials, and energy, have been disproportionately impacted by the economic slowdown. Most of the cyclical sectors are not expected to recapture their 2019 earnings level until 2022.

Market Not Cheap, but Not in A Bubble Either

When we review the sector earnings with valuations, it suggests that the market is expensive but not at bubble levels. Based on 2021 estimates, the majority of sectors are near the same price-to-earnings (P/E) level that they traded at the end of 2019. Energy is one sector where the 2021 P/E remains elevated due to the collapse in earnings. Consumer discretionary is the other sector that trades at a premium valuation relative to 2019—this is partly due to Amazon, which has a 23% weighting in the sector and is trading at an estimated 2021 P/E near 75, while earnings of other areas within the sector, such as airlines, are depressed.

On an absolute basis, valuations for the broader market remain elevated based on the most traditional valuation metrics. However, in our view, valuations are more reasonable in the context of massive monetary support, low inflation, very low yields and the lack of compelling investment alternatives to stocks.

Since the end of 2019, the 10-year US Treasury yield has moved down from close to 2.0% to the current level of 0.7%. Thus, even when accounting for depressed earnings, the equity risk premium—which compares the market’s earnings yield to interest rates—suggests stocks remain attractive on a relative basis. This is a similar message provided by the S&P 500’s dividend yield advantage relative to the 10-year US Treasury yield which is at the highest level since the 1950s.

Bottom Line

From an investment perspective, even though there is large variability in the earnings outlook, there are factors that provide guidance as we make investment decisions. Similar to 2009, the stock market, which tends to be forward looking, bottomed several months before earnings. The earnings picture is now gradually improving and should continue to do so as the economy reopens, albeit with fits and starts. Many of the growth and defensive sectors are poised to see earnings rebound close to their former highs over the next year, though cyclical shares will remain most sensitive to the economic outlook. Accordingly, we maintain a modest growth bias with equities for now.

Valuations on an absolute basis for stocks are expensive but less extreme on a relative basis. Thus, over a 12-month period, we retain an equity bias relative to fixed income and cash, even while we continue to expect markets to remain choppy near term as they digest the strong gains from the March low.


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