Economics

Stocks Realize Painful Reality: 2020 Won’t Have EPS Growth

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Stocks Aren’t That Cheap

Currently, the stock market’s sharp decline is drawing everyone in. It’s addicting to watch such a vicious decline. Since this was the fastest 10% decline from a peak, we are watching market history. Because stocks have fallen so fast, the natural first inclination is to buy the dip. This isn’t necessarily bad idea. It depends what you are buying and what prices you are paying obviously. 

However, don’t confuse dip buying with a once in a lifetime opportunity. In some instances, stocks aren’t even getting cheaper when they fall. That’s because if stocks fall because of a negative impact to their earnings, they are being valued at the same level as before the decline if the negative catalyst is perfectly priced in.

The market is probably over-correcting because uncertainty is always a negative. If the worst case scenario doesn’t play out, we could see a rally. However, the only sure instances where stocks are cheaper are when we know their earnings won’t be hurt by the coronavirus. For example, Altria, which owns Marlboro cigarettes among other brands and investments, probably won’t see an impact to its earnings, but its stock is down in the double digits.

We are starting to see the first updated estimates for 2020 earnings that are baking in the impact of the coronavirus. As you can see from the chart below, baseline 2020 EPS will only be $165 which is down $9 from before the coronavirus hurt estimates. That equates to just 0% EPS growth. That’s what the market is now pricing in, plus some uncertainty. 

Markets usually over correct because of uncertainty. There was a lot of forced selling in the market this week as stocks like Waste Management cratered even though it won’t be hurt by this virus. Funds are being liquidated because of terrible trades and client nerves.

The stock market fell so viciously because the entire premise of the 2019 rally was undone. Traders may have gotten too optimistic, setting the market up for a minor pullback. That combined with the coronavirus was a death knell for equities. At the peak 2 weeks ago, the S&P 500 had a PE ratio of 19.1. It’s a disaster when stocks have a high multiple and earnings estimates crater. Expected earnings were too high AND valuations were too high. Valuations have obviously come in because of this decline.

PE multiple as of the open on Friday was 16.5. That’s a more normal valuation, but don’t expect stocks to rally back to where they were 2 weeks ago because estimates are still too high. It makes no sense to expect stocks to hit new record highs within the next few months if the multiple is near average based on estimates that are too high. 

Average 5 year PE ratio is 16.7 and the 10 year average is 15. One positive is that rates have fallen to new record lows which means valuations should be higher than normal. Apple stock at one point in Friday’s selloff had a higher dividend yield than the 10 year yield. Apple isn’t known for paying a good dividend.

Financial Conditions Tighten: Fed Will Act Appropriately

Fed chair Jerome Powell made a statement in the midst of the selling on Friday. Powell said, “the coronavirus poses evolving risks to economic activity. The Federal Reserve is closely monitoring developments and their implications for the economic outlook. We will use our tools and act as appropriate to support the economy.” 

That’s effectively a ‘nothingburger.’ He tried to calm the market without needing to resort to a cut in between meetings. I don’t think the Fed needs to cut rates before its March meeting. There’s a good argument to just let this play out on its own. Corrections don’t need to be prevented by the Fed. If markets always think the Fed will save them, it can create a bubble. We see little chance of a cut next week. The fact that he made this statement without the Fed acting shows that markets need to crater more before an intra-meeting cut is made.

Some might be thinking that the Fed can’t do anything to help the economy and markets because it’s the coronavirus that is causing the fear. Fed doesn’t have a vaccine that will cure people. This isn’t a financial crisis. It is fear related to a potential pandemic. While the Fed can’t stop the virus, it certainly can help financial markets. If economic activity craters because of tightening lending standards, it will be tougher to deal with the issue.

As you can see from the chart above, the Oxford Economics financial conditions index shows there is more stress than the peak in December 2018. The Fed partially caused that stress in 2018, while this one wasn’t its fault. That’s bad news because the Fed can more easily fix a problem it created. So I’m now upgrading the number of cuts I see this year to 2 from 1. The market is looking for 3 cuts. There are even some inklings towards 4 cuts. 

When the market recovers from this panic, cooler heads will prevail. Right now, the entire treasury curve is below the Fed funds rate which gives us a strong inkling that the Fed is too tight. Fed probably will cut rates at its meeting on March 18th. There is currently a 69.4% chance of a cut based on the CME Group Fed Watch tool.  

Conclusion

Many investors recommend buying the stocks of companies that won’t be impacted by the coronavirus. You are getting those stocks on sale. Rest of the market will likely rally, but this isn’t the buying opportunity of a lifetime. Remember, stocks were expensive before the crash and estimates are coming down quickly. 

Stocks most impacted by the coronavirus such as the airlines and cruise firms will rally the sharpest when this decline is over. However, there is a reason they fell in the first place. Don’t expect them to recover all their losses anytime soon. 

The post Stocks Realize Painful Reality: 2020 Won’t Have EPS Growth appeared first on Theo Trade.

Source: First Rebuttal

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