Sunday, 5 July 2020

Reality check: Booming sharemarkets are about to face a big test

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The US corporate earnings season starts this week, providing the first full insight into the worst impacts of the coronavirus on America’s biggest listed companies and a reality check for sharemarkets in the US and elsewhere.
While it will be a low-key start, with the big banks and some of the big tech companies due to report next week, the June quarter results will help fill in a vacuum in the market’s understanding of what the market expects - and is pricing in – to be the nadir of American companies’ fortunes.
Results from some of the US's biggest companies will dictate the future direction of markets.
Results from some of the US's biggest companies will dictate the future direction of markets.CREDIT:AP
The June quarter saw lockdowns of huge swathes of the US economy, before the stuttering re-openings of key state economies. It also saw a dramatic rebound in the US sharemarket from its March lows, with the market up almost 20 per cent for the quarter, the best quarterly performance since 1998.
Where the US market goes the rest follow, so the results from the big end of the US corporate sector will have a heavy influence on the direction of other markets, including the Australian market.
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Expectations of the earnings are low even though valuations are high.
The consensus forecast is for a 44 per cent slump in the earnings of the S&P 500 companies, which sits oddly against the surge in the market since late March and is explained mainly by the coincidence of the start of that spike with the announcement of the US Federal Reserve Board’s multi-faceted program to pump liquidity and credit in the US financial system and real economy.
Analysts, in coming up with that forecast, haven’t had a lot of data to work with. About 400 of the 500 companies in the index haven’t provided guidance, with about 200 of them withdrawing previous guidance. The extent of the failure to provide guidance is said to be the worst since the midst of the "dot-com" crash in 2001.
The market is trading at just under 22 times historical earnings, against an historical average of about 19 times earnings, despite the irrelevance of 2019 performance in the post-pandemic environment. The high price-earnings multiple is a function of share prices rising even as earnings crash.
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More relevant, with the consensus for forecast full-year earnings a fall of more than 24 per cent, is the multiple of 2020 full-year earnings of 20.4 times. That is more than third higher than the 10-year average of 15 times and its highest for nearly two decades. The peak forward PE ratio was 23.4 at the zenith of the bubble in technology stocks in 2000.
Moreover, the market is pricing in a rebound of about 26 per cent in full-year earnings in 2021, taking them back close to the level generated last year.
If the swelling coronavirus infection rate isn’t controlled; if the unemployment rate turns back up; if the spate of large bankruptcies continues to increase and if corporate profits don’t rebound in the third and fourth quarters of the year the Fed’s support will look increasingly like it’s actual substance – life-support, not stimulus.
Markets capitalise the future, not the past, so in some respects the expected June-quarter dive in corporate profitability could be discounted as analysts and investors focus on, and price in, the outlook.
In effect – leaving aside the aberrational effects of the Fed’s multi-trillion-dollar interventions – the market is still pricing in a "V-shaped" recovery, with profits regaining momentum through the second half of this year and then into 2021.
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That’s despite the evidence that the US is failing to contain the virus. There were about 330,000 new infections in the US last week, taking the total number of cases since the pandemic reached the US to nearly three million. The daily rate of infections is close to 60,000 and climbing.
The outbreak appears directly related to the re-openings of a large number of state economies, which raises a massive question mark over the market’s implicit faith in a V-shaped recovery.
While job numbers have improved significantly in the past two months and the re-openings have re-started economic activity, the spiralling of infection rates and the recent re-imposition of some limitations of activity in some states suggests that the recovery path won’t look anything like a V.
Given that a half dozen or so big technology companies now account for nearly a quarter of the US market’s capitalisation it is conceivable that stellar performances from companies like Amazon, Google’s parent Alphabet, Apple, Facebook and Microsoft could rationalise an extension of the market’s rally.
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The technology sector as a whole, however, while performing better than the rest of the market, is expected to experience a percentage decline in earnings, relative to the same period of 2019, in the low teens.
The near-term fate of the markets will be written, one suspects, in the results from this quarter and next – unless Congress authorises new fiscal support, much of the increased benefits paid to the unemployed that were its initial response to the pandemic will fall away.
That leaves the Fed and the market’s faith that the Fed will continue to underwrite investors’ risks and reconcile the extent of the disconnect between what’s happened in the markets since March, what’s happened in the real economies and what’s likely to happen if the V-shaped recovery the market has priced in doesn’t eventuate.
The apparent complacency of investors also assumes that the markets will continue to generally ignore the increasing friction, and number of friction points, in the deteriorating relationship between the US and China, the world’s two largest economies.
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If the swelling coronavirus infection rate isn’t controlled; if the unemployment rate turns back up; if the spate of large bankruptcies continues to increase and if corporate profits don’t rebound in the third and fourth quarters of the year the Fed’s support will look increasingly like it’s actual substance – life-support, not stimulus.

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The markets might find it rather difficult, in the face of another economic downturn, to use the Fed’s response to an economic crisis to rationalise a market that, on its fundamentals, is in (or is at least close to) territory that looks more like a bubble than something sustainable.

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