Valuing stocks based on what companies are expected to earn over the next year presents some thorny problems. That doesn’t mean investors shouldn’t pay attention to those expectations.
The Covid-19 crisis has put earnings estimates through the wringer. Over the next four quarters, analysts polled by Refinitiv forecast that earnings for companies in the S&P 500 will be down about 20% from a year earlier. At the start of the year they expected earnings growth of over 10% for the same period.
The collapse in earnings estimates, in combination with stocks recovering much of the ground they lost earlier this year, has sent price/earnings multiples sharply higher. The S&P 500 now trades at 21.6 times expected earnings, putting its forward P/E into territory last seen during the dot-com bubble.
That P/E ratio is a bit deceptive since it reflects expectations during an unusual period of turmoil. Once the threat passes, allowing people to go back to something like their prepandemic lives, earnings will to some extent bounce back. And since stocks are supposed to be valued on expected earnings that extend well beyond the next year, there is some sense in looking past what is happening now.
But not in ignoring it. The S&P has now climbed back to where it was at the end of October. Back then, expected earnings over the following 12 months were about 25% higher than now, putting the index’s forward P/E at 17.4—still on the expensive side.
Even if the earnings lost as a result of the pandemic are temporary, they still count as losses. The profits one would expect companies to earn over the next decade are lower now than before the novel coronavirus took hold. So while basing the level of a stock index on a P/E ratio distorted by a crisis like the pandemic is shortsighted, the level of stocks really should hew to what is expected over several years, which is now meaningfully lower.
Moreover, it will probably take more than a year for profit levels to bounce back. Wall Street analysts tend to be optimistic about earnings at the companies they follow, and their estimates veer more toward a V-shaped recovery in the economy than the more drawn-out affair many economists are penciling in. Even so, they don’t think profits will return to last year’s level until 2021. Since the end of October, their forecast for the S&P 500’s earnings next year has fallen by 17%.
Earnings expectations aren’t the only driver of stocks, of course. The collapse in long-term interest rates since the crisis struck probably has left many investors with the feeling that there is nowhere else to stick their savings. And the massive monetary and fiscal stimulus already put in place may have convinced many that if stocks falter again, the Federal Reserve and elected officials will come riding to the rescue.
But as the expected collapse in earnings over the next year starts to become a reality, investors’ faith in the stock market could be put to the test.