We often get asked why certain things happen in the market. There are always narratives floating out there, but the truth is that the “market” is not a hivemind that moves for one specific reason. When looking at the current move off of the bottom of the recent market lows, it is interesting to ask ourselves why is this happening? We have seen the first round of Q1 2020 earnings reports come in, and they have not been pretty. According to Bloomberg with 10% of companies in the S&P 500 reporting, Q1 earnings per share (EPS) are down -35% year-over-year. When contemplating this dreadful data point, remember that this quarter experienced just the beginning effects of the global lockdown on global demand.
We have seen banks begin to provision for large losses from small company loans, credit card debt, and mortgages. Don’t be surprised if they have to do this again in July with the release of the Q2 2020 data. We are seeing loan covenants redrawn or being thrown out the window as companies without revenue are drawing down credit facilities to cover short-term expenses
All this to say that when the equity market continues to rally into bad news it can be confusing. Looking at forward valuations, which is what many analysts traditionally look at, we can see the disconnect. Valuations, specifically price-to-earnings or P/E ratios, are spiking to pre-COVID numbers. We are seeing forward estimates of earnings beginning to fall, though not by very much yet. So as price (the numerator) rises and earnings (the denominator) falls we will see this valuation number continue to spike.
Generally during an economic crisis, valuation multiples like P/E contract as few are willing to pay up for growth that may not materialize. That may happen here, but it would require a crash in prices. Or it may require that every just pretend that 2020 does not exist. During the great financial crisis of 2008, our banks went in too levered and deleveraged to get out of the crisis. Currently our companies went into this crisis levered up, and most are re-levering to get out of the crisis.
But not everything is bad. We are fighting a common enemy again. As a country, we are following the rules even when it is difficult. Americans have become good at social distancing. Looking at air travel in the US, we can see that through 4/15 we have shut down the economy. Americans are making huge sacrifices for the greater good. That is encouraging. Let’s keep the feeling of togetherness after we have vanquished this enemy.
We are all giving new meaning to the old turn of phrase “safe as houses”, we hope you are as well. We are continuing to watch the markets daily as we wait on warmer weather to provide us some relief.