May Investment Comments
The S&P 500 followed up its more than 30% total return in 2019 with a decline of 20% in the first quarter of 2020. That understates the severity of the move, as small- and mid- cap stocks were down 30%, and at its lows the S&P 500 was 35% off its recent peak. In March, the S&P 500 moved an average of 5% per day, the most of any month on record.
Nobody is certain about the extent of the damage done to the economy as a result of efforts to combat COVID-19. We do know that there has been a severe demand shock that will result in a sharp economic contraction and a meaningful decline in corporate earnings. In response to these concerns, the Federal Reserve Board, Administration, and Congress moved to support workers and businesses with programs to preserve as much of the economy as possible while large portions of the country are shut down.
The Fed moved aggressively and cut interest rates to nearly zero, making credit widely available. Reinstituting programs put in place during the 2008-2009 financial crisis allowed the Fed to move quickly. Of particular note is the Fed’s decision to reengage in quantitative easing, including the purchase of corporate bonds, some high-yield. During the financial crisis the Fed grew its portfolio of securities from $800 million to $4.5 trillion, and ultimately reduced its holdings to approximately $3.8 trillion during the recent expansion. The recent asset purchases have increased the Fed’s balance sheet to over $6.1 trillion as it works to keep markets functioning smoothly. This number will grow.
On the fiscal side, Congress passed the CARES Act at the end of March. This was a $2.2 trillion economic rescue program that included loans and other disbursements to a broad portion of the economy, including payments to Americans and loans to large and small companies. President Trump is pushing for additional stimulus, and Congress has begun initial discussions around what another round of stimulus might look like. The ultimate amount of economic support required will be dictated by the length of economic disruption, which remains uncertain.
While the need for this backstop is apparent the support comes with a substantial cost. Goldman Sachs estimates that the federal government budget deficit is on track to reach a record $3.6 trillion in the current fiscal year. There is some question as to what the impact of the virus and subsequent government intervention means for inflation/deflation over a longer time horizon and this will be closely watched and debated.
In response to the actions taken by the Fed and Congress, stocks have rebounded, up 25% from the March 23rd lows as of this writing, technically bringing them into a new bull market. This recent surge included the largest weekly rally for stocks since 1974. However, even after rallying 25% the S&P remained down 18% from highs achieved earlier this year.
The recent market rebound has come despite grizzly economic data. Nearly 17 million Americans have filed for jobless benefits in the past three weeks, equivalent to approximately 10% of the U.S. workforce. Companies have furloughed employees, cut investment, and drawn down credit lines in an attempt to bolster liquidity. To put the recent job losses into perspective, 8.7 million jobs were cut from payrolls during the 2007-2009 recession. Economists at several large banks have forecast GDP to contract at an annualize rate of 30%-40% in Q2, with a mid-single digit decline for all of 2020.
What does this mean for earnings in 2020? Many companies that previously provided guidance have understandably withdrawn it due to the highly uncertain environment. We have heard a consistent theme—that the year started off strong but things started to slow meaningfully in late March. As companies report Q1 results we will get a better idea of the impact to businesses and what companies expect going forward.
Currently, FactSet projections, which reflect an aggregation of analyst expectations, show earnings are expected to decline 11% in Q1. Full year projections show an 8% year-over-year decline in S&P 500 earnings in 2020. This is down meaningfully from expected growth of over 9% at the end of last year. However, many analysts have yet to fully reduce their estimates in response to the virus, meaning the true consensus number is likely lower. Analysts at BofA Global Research project a 29% decline in earnings this year and Goldman Sachs has estimated a 33% decline.
Given the uncertainty reflected in the relatively wide dispersion of current projections, trailing numbers might provide a better estimate of the true earnings power of the market. Stocks currently possess a trailing P/E of just over 17x, approximately in line with the 10-year average. This indicates some belief on the part of investors that a return to normalcy is not expected to be a multi-year journey and that the shock to the economy will be relatively short-lived. A trailing P/E of approximately 17x results in an earnings yield of 5.8% compared to the current 10-year Treasury yield of approximately 0.7%, down from 1.9% at the start of the year.
The question becomes, when will things begin to normalize? And then, what is the longer-lasting impact from such a demand shock? Recent data has generated some optimism that U.S. infections may be hitting a plateau. However, other countries have seen similar declines in infection rates, only to face subsequent rounds of infections as they began to reopen their economies.
Though estimates vary, the consensus from health experts suggests continued restrictions on activities and stay-at-home orders through at least May. Dr. Anthony Fauci, the director of the National Institute of Allergy and Infectious Diseases, has indicated that parts of the country might be able to start pulling back on social distancing guidelines as soon as May, though the speed at which those guidelines are relaxed nationwide is highly uncertain. Even once guidelines are relaxed consumers need to feel comfortable reengaging. A vaccine (estimated to take 18 months to develop) or therapeutic would help meaningfully. The success of government programs in building a bridge to the other side of this demand shock will also help determine what kind of recovery we ultimately experience.
Over the long term it rarely pays for investors to be pessimistic. Certainly the world won’t look the same even once we return to “normal.” The pandemic has accelerated some existing business trends such as the shift to digital. Furthermore, there will likely be a shakeout where some weaker players are no longer around, meaning companies with already strong market positions will likely see those advantages strengthen. Owning companies that can successfully navigate the current environment and emerge with improved competitive positioning is one reasonable recipe for success.
James M. Skubik, CFA