US stocks have bucked the coronavirus downturn, but will corporate earnings halt their buoyancy?

The recent rebound in equities has been prompted by aggressive fiscal and monetary stimulus from central banks and governments, and a belief that the worst of the pandemic has passed. A deterioration in corporate earnings could stymie this trend.

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Visitors walk through Disneyland Park on February 25 in Anaheim, California. The crisis has cost Disney US$1.4 billion in lost profit last quarter. Photo: Getty Images/AFP

Published: 8:00pm, 8 May 2020Updated: 10:23pm, 8 May 2020

Equity markets around the world have rallied sharply since the March low. The S&P 500 bounced back strongly and quickly; by the end of last week, it had regathered over half of the fall from its peak in February. The pace of the rebound in markets is as remarkable as the head-snapping velocity of the decline.

Some investors may be getting that familiar feeling of being left on the sidelines. It’s like being overtaken by a speeding driver in a flashy car on the highway – I might briefly envy their fast ride, even as I know their risk of losing control is much higher.

These surprisingly buoyant equity markets, which have been bolstered by aggressive monetary and fiscal support, effectively mean that investors are prepared to pay a lot more for corporate earnings.

When purchasing a stock, you’re simply buying a “share” in the future earnings of that company. One way to measure this is the price-to-earnings ratio. The PE ratio is like a yardstick for whether a stock is too cheap or too expensive.

At the market low, the PE ratio for the S&P 500 was 13 times, but since the market has rallied, the ratio has risen to over 19 times. This means that the US equity market is more expensive today than it was at the market peak in February, when the consequences of the global pandemic were still not fully appreciated.

These elevated valuations may not be sustainable and depend largely on where company earnings finally land, which is anything but certain.