Following the fastest bear market drawdown in U.S. history, markets gained positive momentum through mid-May. From mid-February to late March, the S&P 500 Index dropped roughly 34%. Since then, the Index has recovered with a gain of nearly 20% from the trough. In addition to the stock market recovery, the U.S. and the rest of the world began planning for a gradual reopening, as many public health experts suggest the peak of coronavirus infections has been reached.
First quarter earnings were remarkably low, as many businesses suspended operations and shelter-in-place orders were enforced globally. As of May 15, the blended earnings (combination of actual earnings reported and estimated earnings for companies that had not yet reported) decline for the S&P 500 in Q1 2020 was -13.8%. If this were to be the quarter’s actual decline, it would mark the largest year-over-year decline reported since Q3 2009, when earnings dropped by -15.7%.1 As many U.S. states begin to reopen, economic activity will pick up, and earnings are expected to increase. However, given the uncertainty that still surrounds the pandemic, businesses may not be operating at full capacity and consumers may remain cautious about increasing spending. So, the extent to which economic activity increases in the near term remains to be seen.
Earnings Recovery Journey
One commonality among all past recessions was the long journey to earnings recovery—on average, it took nearly three years of volatility before earnings reached their pre-downturn peak levels. However, the way equity markets behaved during past U.S. recessions did not consistently reflect earnings expectations. For example, in the 1990-91 recession, 12-month forward EPS hit its trough well after stocks had regained momentum. However, with the tech bubble recession in the early 2000s, 12-month forward EPS bottomed nearly a year before the market did. And lastly, the Global Financial Crisis in 2008-09 experienced earnings and equities falling at about the same pace, with the market bottoming only two months before EPS expectations hit their lowest point.
Anticipating what the road to recovery will look like for the current recession is complicated by coronavirus unknowns and the related difficulty in forecasting earnings. Of course, we don’t yet know whether the market has bottomed. Typically, investors start to feel confident that the worst has passed when they can see earnings downtrends start to turn positive, but many analysts are continuing to decrease their expectations for Q2 2020 earnings. Consensus estimates speculate that second quarter earnings will be down 50-60% from Q2 2019 levels. If these estimates prove to be correct when second quarter earnings are reported (typically August), it’s possible it will trigger another wave of volatility, and potentially, a new market bottom.
We believe a cautious approach is warranted as many unknowns remain. In particular, we continue to focus on investments backed by high-quality companies and management, on the possibility that the economic recovery could be uneven and choppy for some time. Market volatility may remain elevated until the range of potential outcomes begins to narrow. We see the current stock market risk/reward as less compelling following the recent rally because equity valuations are not cheap at current levels. The strong rebound in stock prices despite many unknowns surrounding the pandemic indicate to us that the world may not be out of the woods.
We recognize that corrections and bear markets are a normal part of investment cycles and can create attractive buying opportunities for investors that are long-term focused and willing to take on risk while others are fearful. At the same time, with an understanding of the exceedingly challenging combination of circumstances investors are faced with, we appreciate that fear is natural. We will look for additional opportunities to selectively increase risk, if further stock market pullbacks develop. In the meantime, we will focus on dislocations in various niche markets that present attractive risk/rewards.
The opinions and analyses expressed in this newsletter are based on RMB Capital Management, LLC’s (“RMB Capital”) research and professional experience, and are expressed as of the date of our mailing of this newsletter. Certain information expressed represents an assessment at a specific point in time and is not intended to be a forecast or guarantee of future results, nor is it intended to speak to any future time periods. RMB Capital makes no warranty or representation, express or implied, nor does RMB Capital accept any liability, with respect to the information and data set forth herein, and RMB Capital specifically disclaims any duty to update any of the information and data contained in this newsletter. The information and data in this newsletter does not constitute legal, tax, accounting, investment or other professional advice. Returns are presented net of fees. An investment cannot be made directly in an index. The index data assumes reinvestment of all income and does not bear fees, taxes, or transaction costs. The investment strategy and types of securities held by the comparison index may be substantially different from the investment strategy and types of securities held by your account. The S&P 500 Index is widely regarded as the best single gauge of the U.S equity market. It includes 500 leading companies in leading industries of the U.S economy. The S&P 500 focuses on the large cap segment of the market and covers 75% of U.S. equities.