First-quarter profits shrank at the fastest rate in over a decade. Analysts don't like what they see coming down the pike. Investors keep pushing stocks higher.
Wall Street analysts have grown increasingly pessimistic in recent weeks about the outlook for corporate profits, even as investors have pushed markets steadily higher, breaking the link between analyst forecasts and the direction of stock prices.
Most companies in the S&P 500 stock index have reported their first-quarter earnings, and the effect of the coronavirus pandemic on profits is becoming clear, at least for January through March. On a per-share basis, profits of S&P 500 companies fell 13 per cent, making it the worst slump since 2009.
Analysts think things will get worse before they get better. At the end of March, the consensus among analysts was that profits at companies that make up the index would sink a modest 1.8 per cent in 2020. But after digesting the financial reports of companies from Agilent Technologies to Zions Bancorp, they now think 2020 profits will tumble more than 20 per cent.
Any finance textbook's section on equity prices holds that the direction of the stock market is determined, to a large extent, by the profits and dividends that shareholders expect companies to produce in the future. And academic research has repeatedly shown that when Wall Street analysts revise their forecasts for a company's profits, it can move share prices.
Traders and investors routinely take note of when analysts erase earlier expectations, using those revisions as a real-time gauge of how the fundamental business prospects of corporate America are looking.
Going by the conventional wisdom, the current collapse in profit expectations — and analysts' woeful prognoses — should be clobbering share prices. But investors don't appear to be taking their cues from analysts. The S&P 500 has soared more than 30 per cent over the past two months.
To be sure, investors priced in some downturn in profits when stocks suffered a 34 per cent collapse in February and March. They were right, and the pain, reflected in earnings reports, was widespread.
Bank earnings were fairly awful. Quarterly profits at JPMorgan Chase, Wells Fargo and Bank of America all undershot Wall Street expectations, and numbers from credit card issuers like Capital One and Discover were also ugly.
Firms that rely on discretionary consumer spending were, unsurprisingly, hammered. Casino operator Las Vegas Sands posted a first-quarter loss of US$51 million, compared with a profit of US$744 million during the same period last year. Profits fell 92 per cent for hotel company Marriott International. Cruise line Carnival lost US$781 million during the first quarter. Even Amazon.com, ideally positioned for a world reliant on home deliveries, saw profits fall 29 per cent as the costs of keeping open during the crisis increased.
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Over the past few weeks, disappointing earnings announcements sent share prices down 1 per cent on average. (That's far less than the nearly 3 per cent drop stocks suffered on average after falling short of expectations in recent years, according to research from data provider FactSet.)
Close observers of stocks won't be surprised. After all, market sentiment has grown increasingly detached from the abysmal outlook for economic growth, another supposedly fundamental building block of market prices. Instead, stocks have climbed even as the consensus expectation among Wall Street economists forecasts a 30 per cent annualized rate of decline for gross domestic product this quarter, according to FactSet.
Plenty of explanations have been offered to help explain the market's blasé approach to a bleak reality facing corporate America. Some say the bad economic news was already priced in during the March collapse. Others argue that markets are simply "discounting" — that is basically betting — that the US will enjoy a V-shaped, or robust, economic recovery. Another argument is that investors, who tend to be forward-looking, are simply setting their sights on a future where the pandemic is a distant memory.
The most powerful reason is simpler: It's the actions of the Federal Reserve.
Since March 23 — the day the stock market rally began — the Fed has done its best to ensure that the returns on bonds are quite low by signaling its willingness to buy unlimited quantities of Treasury and government-backed mortgage bonds. It has also ventured into buying corporate bonds, which helped push yields on such bonds lower too. The goal, in part, is to push investors away from the safety of the bond markets and into riskier assets, like stocks.
In a recent note, analysts at JPMorgan argued that these programs by the Fed probably have "a bigger positive impact on equity valuation, compared with the negative impact of the temporary earnings loss."
Translation: The Fed's efforts to keep interest rates and bond yields low have more than offset the collapse in profits for S&P 500 companies, helping to keep the market aloft even though corporate profitability and the economy look likely to be gloomy for a while.
A similar thing happened during the last financial crisis. Interest rates and bond yields fell to low levels that would have been unthinkable previously, which many partly attributed to central bank actions. And for the years that followed, prices of assets such as stocks, bonds and real estate all rallied to levels that looked high relative to the sluggish level of economic activity after the crisis.
So while corporate profits are supposed to be the fuel that revs the stock market's engine, in the short term, Federal Reserve policy remains in the driver's seat. That explains why investors are willing to ignore what analysts have to say, at least for the moment.
Written by: Matt Phillips
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