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.