Earnings season will tell if stock market optimism is justified
- Most market watchers predict a drop and bounce-back in profits sharp enough to be called V-shaped. If they are right, the reporting of second-quarter company earnings now under way should reflect a turning point in global profits downturn
Meanwhile, in the real world, while economies are getting back on their feet, they have a long way ahead to fully recover.
A key reason for this divergence is markets’ forward-looking nature: it means they have been able to move well ahead of the real economy to price in an expected recovery in corporate profits – the fundamental driver for stocks. That’s why prices anticipating earnings growth in the future look expensive today. At some point, however, earnings will need to catch up and justify investors’ rosy optimism about future growth.
What should help is that the make-up of stock markets around the world is quite different from that of economies. Details vary across regions, but the basic trend is consistent: manufacturing is over-represented in equity markets, while services are under-represented.
For instance, in the United States, the various forms of manufacturing account for over a third of the stock market’s value, but only around 10 per cent of US GDP and employment. Services are much more important in the economy than in the stock market.
So what to expect from here? Most market watchers predict a drop and bounce-back in profits sharp enough to be called V-shaped. US second quarter earnings are expected to be down by 40-45 per cent compared to the same period in 2019, and in Europe and Japan by 55-60 per cent. To put these very substantial falls in context, during the worst quarter of the global financial crisis, US stock market profits dropped by 65 per cent, driven by huge losses in the financial sector.
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The rebound in the second half of this year should be almost as steep: by the end of this year, US quarterly profits are expected to have already recovered 70 per cent of their peak-to-trough fall, and to be only 13 per cent below their pre-Covid level.
By the second half of next year, they are even expected to be reaching new record highs, and that also applies to global stock market profits. Overall then, global profits are expected to go from a pandemic-driven collapse to new record levels in around 18 months.
Asia’s growth profile looks a bit different, given our relative success in containing the virus. For emerging markets Asia equities, flat profits in 2020 are expected to be followed by a growth of 25 per cent, also to new record levels in 2021.
With these cheerful predictions, it is easier to understand why stocks recovered so quickly, but also how important it is that expectations are at least proven somewhat accurate during this reporting season. Experience also teaches us that analysts are almost always overly optimistic about next year’s profit growth and we should be prepared for wishfully positive 2021 expectations to be cut back over time.
Market sentiment has been remarkably resilient in the face of great economic suffering, but it’s not a foregone conclusion that stocks will continue to rise, especially if the turnaround investors envision doesn’t materialise.
Patrik Schowitz is a global multi-asset strategist at JP Morgan Asset Management