The stock market is back, baby!
After falling over 30% from late February to late March, the S&P 500 has fought its way back to within about 5% of its all-time high. The tech-heavy Nasdaq Composite has done even better, reaching new records in recent weeks. It all seems a bit incongruous with the damage the Covid-19 crisis has visited on corporate profits, but one interpretation is that investors are looking through the bad times to the return to normal.
There actually is some sense to this explanation, but investors never exhibited so much foresight in past recessions.
Companies have been reporting second-quarter results this month, and they haven’t been good. For the S&P 500, current estimates show profits will be down about 37% from a year earlier, according to Refinitiv (excluding “one-time items” such as restructuring charges), marking the sharpest decline since the financial crisis struck in the fourth quarter of 2008. Analysts don’t expect earnings to grow again until the first quarter of next year, and they forecast that it won’t be until 2022 that profits will be meaningfully above 2019 levels. And these are Wall Street analysts we are talking about, who have a reputation for being overly optimistic.
Even if the reality is gloomier than analysts think, though, arguably the underlying value of stocks hasn’t fallen that much despite the Covid-19 earnings hit. That is because stock prices are supposed to reflect the expected income streams their underlying companies generate over the course of many decades. A halving of earnings for a year or so, and then a snap back to normal, might only knock a stock’s true value down by about 5%.
That is how it works in theory, but not in practice. Crashes often present rich pickings for those who wait for the theory to catch up. The great economist and speculator John Maynard Keynes remarked in 1936: “Day-to-day fluctuations in the profits of existing investments, which are obviously of an ephemeral and non-significant character, tend to have an altogether excessive, and even an absurd, influence on the market”
In the most recent example, U.S. stocks fell by a multiple of their lost earnings following the financial crisis. It wasn’t until early 2013, over four years, before they had recovered to the extent they just did in four months. The stock market decline following the dot-com meltdown twenty years ago was also disproportionate, and the ensuing recovery was even more prolonged.
Of course that isn’t the only way in which investors are irrational. At the record highs stocks logged just prior to the Covid crisis, valuations looked steep, as is often the case toward the end of bull markets. The sharp decline the market has experienced didn’t simply reflect excessive pessimism among investors but the excessive optimism that preceded it.
Every recession is different, though, and perhaps this is one where it is easier for investors to envisage the eventual recovery than in past downturns. There is substantial uncertainty about what course the coronavirus might take in the months ahead, along the unemployment rate is above its highest levels following the 2008 crisis and gross domestic product just registered its sharpest downturn on record in the second quarter. A newfound belief in profits’ ability to recover seems dubious.
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Rather than concluding that investors have finally become Warren Buffett-like and that they are less focused on companies’ near-term travails than in the past, it is worth asking whether something else is going on. For example, maybe the response the Federal Reserve mounted to the Covid-19 crisis, which has dwarfed its financial crisis responses in both speed and scope, has convinced investors more than ever that the central bank will do whatever it takes to prevent markets from being disrupted. The same goes for the massive stimulus the federal government put into place this spring.
Either way, their confidence will cut into future returns. It usually takes several years for stocks to make up the ground lost in a bear market and a lot of gains are front-loaded. In this case, though, a bigger-than-usual chunk of the current bull market may have already been eaten up.
And what if the safety net investors believe Washington has put in place below the market is flimsier than they suspect or the pandemic’s future path even worse? Well then investors might revert to their usual form and run away from stocks again.
Write to Justin Lahart at justin.lahart@wsj.com
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