Falling earnings, higher P/E
Clearly, earnings are an important part of this equation. So, what does it mean when, in a time like this, analysts are forced to cut their Q2 earnings estimates for S&P 500 companies by a whopping 28.4%? It means that, all of the sudden, people are paying a lot more for a company’s future earnings. You would think that if earnings were expected to fall by nearly 30%, stocks would also fall by an ungodly amount, and then the market wouldn’t look so expensive. But, as I’ve written before, investors remain optimistic that the pandemic, and its economic effects, will be short-lived.
Normally, a 22 times P/E would cause consternation among many investors, but Bill Dye, head of Canadian equities at Vancouver’s Leith Wheeler Investment Counsel isn’t paying much attention to the metric these days. “When people say the market is expensive on 2020 earnings, those are depressed earnings,” he says. “That’s not a reasonable way to look at it.” He also says that if you look at where the S&P 500 is trading today, using 2019 earnings, the market would be trading at about 17.5 times earnings.
Investors should look beyond this year and consider 2021 or 2022 earnings to get a more accurate view of the market’s valuation. “The market can look through this recession and say, ‘I’m going to put a multiple on the more normalized earnings we’ll see in the next few years,’” Dye says. If earnings do get back to last year’s levels, then a valuation of between 18 and 20 times may be more reasonable, he says. That’s still not cheap, but it’s at least closer to historical norms.
The one problem is that it may be difficult to determine what kind of earnings the market, or a company, will have post-pandemic. Some businesses will rebound, some may post higher earnings and others will have trouble getting back to where they were. Investors can look at how a company fared during the last recession, or how well they were doing before COVID-19, to decide what sort of earnings they may have in a year or two, but not knowing what’s to come will make it difficult for investors to figure out whether the market, or the company they’re interested in, is cheap or expensive right now.
Saying that, cyclical stocks look better from a valuation perspective than defensive stocks, which are typically more value-oriented, says Dye. In a recession, investors scoop up defensives, like grocery stores and other consumer staples, pushing their valuations higher. Cyclical companies, where fortunes can rise and fall based on the economic environment, tend to get hit hard, but then rebound during the recovery. “We’ve seen some cyclicals come back, but not much as people are still concerned about the outlook for the economy,” he says. “We’ll see that rotation, but it hasn’t happened yet.”
Like everything in this pandemic, nothing makes a lot of sense, so if you think something is odd, like high market valuations, then dig a little deeper to find out more about what’s going on. You never want to base an investment decision only on P/E, but that’s especially true today.
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