Monday, April 6, 2020

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Stocks bottom long before the economy does

The economy is getting slammed by the lockdowns triggered by the coronavirus pandemic, and most agree it’ll get much worse before it gets better.

However, we cannot rule out the possibility that the stock market, which touched a low on March 23, may have already priced in most if not all of the bad news to come.

“While the world seems to be heading for such a sharp slowdown, equity prices might not fall much further in our view, for two reasons,” Capital Economics’ Simona Gambarini wrote on Thursday.

“First, the recession could potentially be very short-lived, so output and earnings could recover more quickly than they have done in the past,” she said.

Many economists are on board with this expectation for a “V-shaped” recovery as the U.S. households and businesses entered the crisis in pretty good financial shape; in other words the recession was not caused by excesses or imbalances. And while some have tried to compare this pandemic to a natural disaster, it’s critically important to note that any recovery won’t be delayed by a need to rebuild damaged or destroyed capital goods and property.

“Second, prices appear to reflect a much less benign economic outlook than analysts’ current expectations for earnings,” Gambarini said.

Indeed, the S&P 500 (^GSPC) has tumbled 35% from peak to trough, even though most strategists are expecting a much more modest decline in earnings. According to FactSet, the average strategist expects earnings per share (EPS) to decline just 4.5% in 2020. Goldman Sachs, by far the biggest bear among the bulge bracket firms, sees EPS falling 33% to $110.

In other words, the stock market is either already prepared for worse news or it has overcorrected. Both are conditions that would make for an attractive entry point for stock market investors.

Keep in mind that historically, the stock market has bottomed long before the economy did. In a note published on Wednesday, Capital Economics’ Hubert de Barochez observed that this was the case every time except after the dot com bubble burst.

“That is because valuations were very high when the crisis started, and the [dot com] bubble was still in the process of deflating a year later,” he said. “At the same time, the recession was quite short by past standards.”

Of course, all of these assumptions and expectations depend on the world’s ability to contain the coronavirus.

"The negative wildcard remains the COVID-19 daily infection rate, which is slowing,” JPMorgan’s John Normand wrote on Friday, adding “but remains too high to have much confidence on the duration of lockdowns/social distancing and therefore the duration and depth of the recession.”