Coming Earnings Decline

A principle uncertainty in markets is when the number of COVID-19 cases will stop spiking in America. That helps investors figure out when the shutdowns will end and when the economy will restart. We need to know all this to determine where earnings will be in 2020. It’s easy to write off this year’s earnings, but that’s incorrect. 

Many firms will have major financing issues if the economy is shut down for another few months. That will have major spillover effects into the entire economy. That’s why the Fed decided to take the unprecedented action of buying investment-grade corporate bonds last month.

This concept that 2020 earnings aren’t important is predicated on the idea that this decline will be temporary. If it lasts into 2021, this year’s earnings matter a great deal. The chart below shows the time it has taken for large US earnings to regain their prior peak. 

As you can see, since the Great Depression, earnings have come back relatively quickly. Even though earnings crashed in the last recession, it took less than 5-year to regain the previous high.

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Longest recovery since the Great Depression was in the late 1950s which took over 6 years. In theory, since stocks experience multiple compression in bear markets due to uncertainty, it’s possible that stocks will take longer than earnings to recover from their peak. Multiples were elevated in February 2020. Even if earnings recover in 3 years, it could take 4 years to reach the February high. 

On the other hand, if COVID-19 comes under control in the next few weeks, investors will look towards normalcy and probably push stocks much higher. Once buybacks come back and the unemployment rate starts falling, the market will be on firm footing. A recovery will not likely take as long as it did in the 1930s and 1890s. Especially since the government has been proactive in taking care of people who have been laid off and businesses that have been forced to close

$124 In S&P 500 EPS

It’s important to differentiate EPS estimates. There are bottoms up and top-down estimates. Bottoms up estimates show how each analyst thinks each firm will do. These analysts look at the fundamentals and guidance each firm has put out. It’s hard to lower estimates before concrete changes to the business have come out such as earnings pre-announcements. A top-down estimate looks at the macroeconomy and figures out where profits are headed. They can be adjusted easier when dealing with a shock to the system like a pandemic. 

That’s why Goldman was able to lower its top-down S&P 500 estimate last week to $110 in 2020. Earnings Scout measures bottoms-up estimates. The company itself is calling for $124 in EPS. If that is accurate, then the S&P 500 could fall to 1,860 if it garners a 15 multiple. That means more pain is ahead for stocks as the recent bottom in the market last Monday was 2,237.

The table below shows the latest bottoms-up estimates. As you can see, Q1 estimates crashed to -6.6% growth. That’s a 6.05% decline in one month. Earnings season starts in about 2 weeks. Let’s see if estimates have fallen far enough. We truly have no idea if they have. It was previously predicted Q2 growth estimates would fall to below -15% by April 15th. They are falling at a pace that implies even greater weakness as they fell 1.2% in the last day. 

At that rate, we could see estimates below -25% by the 15th. Earnings estimates typically fall the fastest in the previous quarter’s earnings season. That means we haven’t seen the worst of the decline. In the end, we can expect earnings growth to be -100% or worse as we expect losses.  

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Q4 estimates might end up falling too far because there might be a recovery by then. So far estimates are still too high as the consensus still sees positive growth. When estimates swing to the negative double digits, we can flag it as a potential positive catalyst assuming the number of daily new cases in America has peaked.

A Short Recession?

This current recession can be V shaped, U shaped, or L shaped. They go from the bullish to bearish in that order. The chart below reviews each possibility. That blue line is the V shaped recession. A trough in this recession will be much deeper than any of the ones listed. 

Q2 GDP growth could be lower than at any point in over 100 years, including the Great Depression. It’s important to note that using quarterly annualized GDP growth will be difficult in Q2 and Q3. Q3 will have very easy comps. So quarterly annualized growth will be very strong even if it doesn’t bring the economy back to where it was before this recession.

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Stocks Are Cheap

A few months ago we were talking about how vulnerable small caps were because of the increasing percentage of Russell 2000 firms that were losing money. Now we are in the exact opposite scenario as small caps are cheap. At the bottom last Monday, the S&P 400 had a similar forward PE multiple to the bottom in 2009.

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As you can see from the chart above, the number of Russell 2000 stocks trading at a price to book value less than 1 and the percentage of stocks valued at under 3x their cash are spiking. There are more firms below their book value than at the bottom in 2009. 

It's likely the price to book value measurement has a bigger gap over the price to cash measurement because of the number of energy companies failing. Many energy companies have a price to book value below 1, but few have much cash. That means even if they are down a lot, not as many as you’d normally expect are trading below 3 times their cash on the balance sheet.