In this uniquely repetitive era for all of us, Saturday marked a first for my wife, Sari, and me. Armed with a sharp pair of scissors and with a manic gleam in her eye, she attacked the task of cutting my hair. I do admit to being moderately nervous—but only moderately. After all, she wasn’t taking a blade to any vital organ. In addition, my alternative, which was letting my hair grow until I resembled Ben Franklin, wasn’t very appealing. Finally, a haircut isn’t forever; in due course, no matter how much damage she inadvertently inflicted, my hair would grow back.
Similar consolations appear to be supporting the stock market today. At its worst, on March 23rd, the S&P500 was down 34% from its February 19th high. However, since then it has rallied strongly, and by Thursday was down just 18% from its peak. Of course, 18% is still a big loss, but given that the global economy has essentially ground to a halt due to COVID-19, it may seem surprising that it is not down more.
There are, however, some logical reasons for the stock market not to overreact. First, while the sectors most impacted are a huge part of the U.S. economy, they are less vital to the stock market. Second, with Treasury yields at historically low levels and corporate bonds threatened by the recession, there are few appealing alternatives to stocks. Finally, a recession, like a haircut, isn’t forever. Even in a worst-case scenario, in which an economic rebound has to await the distribution of a safe and effective vaccine, 2021 should be the first year of a strong recovery in both economic growth and corporate earnings.
Looking at these issues in more detail, the entertainment, leisure and hospitality sectors have been almost entirely shut down, as has retailing outside of food, liquor and drug stores. In addition, a multitude of business and consumer services have ground to a halt, while auto sales, construction and parts of manufacturing are also feeling the pain. Energy production is also falling sharply in reaction to a collapse in global oil prices. Some of this will be apparent in the March Retail Sales report, due out on Wednesday and should be more obvious in the April employment report, due out on May 8th. All told, these sectors account for roughly 45% of U.S. payroll jobs.
However, the social distancing recession should have less of an impact on stocks. Taken together, the most affected sectors, which include industrials, materials, real estate, energy and consumer discretionary (excluding online retailing), account for just 22% of the capitalized value of the S&P500. The other 78% of market cap comes from tech, financials, health care, utilities, communications, consumer staples and internet retailing, all of which should be less impacted by the downturn.
Second, partly because of the global recession and partly because of a very dramatic central bank response, both short-term and long-term interest rates have fallen to historically low levels, making prospective long-term returns distinctly unappealing. As of Thursday, the yield on a 10-year Treasury bond was just 0.73%. To put this in perspective, the S&P500 is now down 18% from its peak of almost two months ago and has a dividend yield of over 2%. If it took a full 10 years from today, for the market to get back to that peak, and the dividend yield on stocks averaged 2% over that period, the average annual total return on the S&P500 would be 4% per year over that period, more than 5 times the return on a 10-year Treasury.
Elsewhere in fixed income, even after falling in reaction to the Fed’s announcement of new lending programs, the yields on corporate debt are more generous. However, there are clear risks for many issuers if the recession is prolonged. Municipal yields have also fallen in response to Fed announcements and additional federal aid to state and local governments. While this support of the municipal bond market is welcome from a macro-economic perspective, it leaves yields at generally unattractive levels for long-term investors. In short, stocks look a lot more attractive when compared to the alternatives available in fixed income.
Finally, there is the simple issue of time. This week, the earnings season gets into full swing, with 40 S&P 500 companies due to report. Currently, according to data compiled by Factset, analysts are projecting an 8.5% fall in earnings in 2020 compared to 2019, which would, on the face of it, be a rather modest decline given the massive economic disruption. It is quite likely that the outcome will be worse than this, since some of these analyst expectations may be stale.
However, even if 2020 earnings were much worse than currently expected, investors need to appreciate just how much stock prices depend on long-term earnings. To put it simply, the only thing that makes a stock valuable is earnings—money that can, over time, be distributed to shareholders through dividends, stock buybacks or capital gains. The S&P500 currently carries a P/E ratio of a little over 17 times this year’s expected operating earnings per share. But if the index sells at 17 times this year’s earnings, then this year’s earnings account for just 1/17th of its value. Assuming a positive discount rate, next year’s earnings would normally account for a little less than 1/17th of its value. All of the rest of its value—that is to say, more than 88% of its value—doesn’t depend on the next two years of earnings, it depends on earnings beyond that point.
As a highly simplistic example, if COVID-19 were to wipe out S&P500 earnings in both 2020 and 2021, but leave earnings beyond that point untouched, it would justify a little less than a 12% decline in the value of the index. Back in the real world, we know that under most COVID-19 scenarios, 2020 will be the year of the virus and 2021 will be the first year of recovery. However, provided the economy and earnings stage a strong recovery during 2021, corporate earnings in 2022 should be able to return to levels seen last year. This supports the idea that the stock market’s sharp correction over the past few weeks is a more appropriate reaction to recession than the two near 50% declines seen in the first decade of this century.
There are, of course, still plenty of risks. Over the next few weeks, it is likely that an attempt will be made to reopen some parts of the economy. If this leads to a sharp reacceleration in COVID-19 cases, there may be renewed shutdowns, which would be very dispiriting to the public and likely to the stock market. Alternatively, if things go better than expected on the medical front, massive fiscal stimulus could ultimately lead to higher inflation and interest rates, posing a different threat to equities. Or political change could eventually lead to higher corporate taxes, which would also damage the stock market.
These and other risks remain. However, in a world full of uncertainty, investors should take some comfort that the behavior of the stock market in recent weeks seems like a relatively logical response to a problem that is far greater for health, our way of living and for the economy than for the long-term value of equities.
David Kelly is chief global strategist at JPMorgan Funds.