During the Great Recession, annual operating earnings of the Standard and Poor’s 500 Index (“the Index”) fell 56% from a high of 91 to a low of 40. As the current recession unfolds, the consensus is that it will be worse in depth than the Great Recession, although highly likely less in duration. If you take 44% of the Index’s operating earnings of 157 during 2019, earnings for 2020 would be 69. So far few strategists have come close to forecasting that low a number.
Here’s how one could envision 2020 earnings dropping to 69. The lockdown of the U.S. economy began just three weeks from the first quarter’s end. Now with 88% of companies having reported, first quarter’s earnings are expected to be 20.23, down 47% from 37.99 last year. We are almost midway into the second quarter, and the lockdown is just beginning to end. And if, during the economy’s reopening, the populace isn’t disciplined about social distancing, many states will be forced back into some semblance of a lockdown. It is not a stretch to envision an Index LOSS of 10 in the second quarter, down from last year’s earnings of 40! In that case, Index earnings for the first half would be 10. Furthermore, most Wall Street strategists now no longer foresee a “V” recovery in the last half of 2020. During the second half last year, earnings were 79. To reach 69 for this year, earnings during the last half would have to decline 25%, to 59. To me, that is not an outrageous assumption.
Wall Street’s Bullish Bias — An Asymmetry
Wall Street in aggregate makes more money in bull markets than bear markets. Strategists’ forward earnings estimates tend to be significantly higher than actual earnings turn out to be. There is a tendency to apply average P/E multiples to peak earnings, which can lead to “buying at the high.” On the other hand, strategists don’t apply average P/E multiples to bottom earnings. For example, before the pandemic, strategists were estimating earnings to be 170 for 2020. At the Index high of 3394, the P/E multiple was 20 — not that high, strategists claimed, with interest rates so low. However, 20 times assumed earnings of 69 would suggest an Index price of 1380! I can count on one hand the number of well-known strategists that suggest that low an ultimate Index price.
I don’t expect the Index to fall to 1380 because: 1)the Fed is doing everything in its power to keep the economy from lapsing into a depression; and 2) the probability is high that a viable vaccine will be available in quantity during late 2020 or early 2021. However, a retest of the March 23 low of roughly 2200 is probable once more reasonable 2020 earnings estimates become the narrative.
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