Dismal Earnings, Bullish Stock Investors and the Fed’s Invisible Hand

Wall Street analysts have grown increasingly pessimistic in recent weeks about the outlook for corporate profits, even as investors have pushed markets steadily higher, breaking the link between analyst forecasts and the direction of stock prices.

Most companies in the S&P 500 stock index have reported their first-quarter earnings, and the impact of the coronavirus pandemic on profits is becoming clear, at least for January through March. On a per-share basis, profits of S&P 500 companies fell by 13 percent, making it the worst slump since 2009.

Analysts think things will get worse before they get better. At the end of March, the consensus among analysts was that profits at companies that make up the index would sink a modest 1.8 percent in 2020. But after digesting the financial reports of companies from Agilent Technologies to Zions Bancorp, they now think 2020 profits will tumble more than 20 percent.

Any finance textbook’s section on equity prices holds that the direction of the stock market is determined, to a large extent, by the profits and dividends that shareholders expect companies to produce in the future. And academic research has repeatedly shown that when Wall Street analysts revise their forecasts for a company’s profits, it can move share prices.

Traders and investors routinely take note of when analysts erase earlier expectations, using those revisions as a real-time gauge of how the fundamental business prospects of corporate America are looking.

Going by the conventional wisdom, the current collapse in profit expectations — and analysts’ woeful prognoses for future earnings — should be clobbering share prices. But investors don’t appear to be taking their cues from analysts. The S&P 500 has soared more than 30 percent over the last two months.

To be sure, investors priced in some downturn in profits when stocks suffered a 34 percent collapse in February and March. They were right, and the pain, reflected in earnings reports, was widespread.

Bank earnings were fairly awful. Quarterly profits at JPMorgan Chase, Wells Fargo and Bank of America all undershot Wall Street expectations, thanks to the costs of setting aside large amounts of cash to cover an expected surge in borrowers who can’t make loan payments because they’re suddenly unemployed. Numbers from credit card issuers like Capital One and Discover were also ugly.

Firms that rely on discretionary consumer spending were, unsurprisingly, hammered. The casino operator Las Vegas Sands posted a first-quarter loss of $51 million, compared with a profit of $744 million during the same period last year. Profits fell 92 percent for the hotel company Marriott International. The cruise line Carnival lost $781 million during the first quarter. Even Amazon.com, ideally positioned for a world reliant on home deliveries, saw profits fall 29 percent as the costs of keeping open during the crisis increased.

Over the last few weeks, disappointing earnings announcements sent share prices down 1 percent on average. (That’s far less than the nearly 3 percent drop stocks suffered on average after falling short of expectations in recent years, according to research from the data provider FactSet.)

Close observers of stocks won’t be surprised. After all, market sentiment has grown increasingly detached from the abysmal outlook for economic growth, another supposedly fundamental building block of market prices. Instead, stocks have climbed even as the consensus expectation among Wall Street economists forecasts a 30 percent annualized rate of decline for gross domestic product this quarter, according to FactSet.

Plenty of explanations have been offered to help explain the market’s blasé approach to a bleak reality facing corporate America. Some say the bad economic news was already priced in during the March collapse. Others argue that markets are simply “discounting” — that is basically betting — that the U.S. will enjoy a V-shaped, or robust, economic recovery. Another argument is that investors, who tend to be forward-looking, are simply setting their sights on a future where the pandemic is a distant memory.

The most powerful reason is simpler: It’s the actions of the Federal Reserve.

Since March 23 — the day the stock market rally began — the Fed has done its best to ensure that the returns on bonds are quite low by signaling its willingness to buy unlimited quantities of Treasury and government-backed mortgage bonds. It has also ventured into buying corporate bonds, which helped push yields on such bonds lower too. The goal, in part, is to push investors away from the safety of the bond markets and into riskier assets, like stocks.

In a recent note, analysts at JPMorgan argued that these programs by the Fed “likely has a bigger positive impact on equity valuation, compared with the negative impact of the temporary earnings loss.”

Translation: The Fed’s efforts to keep interest rates and bond yields low has more than offset the collapse in profits for S&P 500 companies, helping to keep the market aloft even though corporate profitability and the economy look like they will be gloomy for a while.

A similar thing happened during the last financial crisis. Interest rates and bond yields fell to low levels that would have been unthinkable previously, which many partly attributed to central bank actions. And for the years that followed prices of assets such as stocks, bonds and real estate all rallied to levels that looked high relative to the sluggish level of economic activity after the crisis.

So while corporate profits are supposed to be the fuel that revs the stock market’s engine, in the short term, Federal Rese
rve policy remains in the driver’s seat. That explains why investors are willing to ignore what analysts have to say, at least for the moment.

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