Because of the sudden shock to economy due to the coronavirus pandemic, the current earnings per share (EPS) estimates are dangerously out of date.
Investors rely on analyst EPS estimates to help them determine whether a company's profits are expected to grow, shrink, or stagnate.
It's a key element in deciding the value of a stock and whether you want to buy, sell, or hold.
But while those estimates have fallen steeply over the past six weeks, they only hint at the true decline in earnings we're likely see through the rest of 2020.
So far, the consensus target for S&P 500 earnings over the next year has come down by 8.4%. Here's the chart of where we stand, which looks grim as is:
But Keith Parker, head of equity strategy at UBS, says that chart doesn't show the true damage that's coming to corporate earnings by about half.
Here's why.
There's great uncertainty over when the coronavirus will be under control to the point that currently paralyzed industries can restart. That has compelled many analysts - about half of them, Parker says - to delay their EPS revisions.
So right now, only about half of the EPS estimates account for the economic impact of COVID-19.
Parker assumes the laggard analysts eventually will revise their earnings per share estimates in line with those that have already done so. Factoring that in puts the "real" decline in the S&P 500 EPS estimate for 2020 at about 16%.
And given the recent bear market rally, it's apparent Wall Street has not priced in such a steep decline...
How Flawed Earnings Per Share Numbers Make Stocks Look Cheap
Earnings per share estimates are used to calculate forward P/E - the price/earnings ratio for the next 12 months. The forward P/E is one measure of whether the market is properly valued.
In the wake of last month's stock market crash, the lower prices dropped the forward P/E accordingly - and made stocks look "cheap." According to Factset data, the S&P 500's forward P/E fell to 13.26 as of the March 23 low. That was a 30% drop from where it was in mid-February, at about 19.
The persistent bear market rally has pushed the forward P/E back up to nearly 18.
That alone should be a red flag that stocks are overpriced right now. But it doesn't account for the drop in EPS estimates to come.
Factoring in the "missing" 8% drop in earnings forecasts puts the real forward P/E of the S&P 500 at about 20 - higher than it was at the mid-February market high.
And it could be worse...[mmpazkzone name="in-story" network="9794" site="307044" id="137008" type="4"]
Ed Yardeni, president of Yardeni Research, sees an even steeper drop in S&P 500 earnings, a plunge of 26.4%. That's more than three times the current estimate.
"Clearly, estimates are cascading down, but there's a long way to go," Yardeni told Investors Business Daily. "They have a lot of chopping to do."
Using Yardeni's earnings per share estimate for the S&P 500 pushes the forward P/E all the way up to 23.3 - a level not seen since the dot-com bubble in 2000.
Frankly, there's a huge amount of uncertainty about when the economy will rebound and how quickly. The struggle to control the coronavirus could drag on much longer than many expect. And attempts to reopen the economy will need to be reversed if they trigger a fresh outbreak of new cases.
In short, this all means investors need to be very cautious about buying into this bear market rally. As the earnings season moves along and we get guidance from more companies, it will become clear just how overvalued many stocks are right now.
That's not to say you can't find quality stocks to buy. But don't be fooled by the illusion that stocks are cheap just because the markets are down about 17.5% from their highs.
How to Invest During the Coronavirus Crisis
While investors need to tread carefully, you don't need to stay on the sidelines.
Money Morning Chief Investment Strategist Keith Fitz-Gerald has some basic rules of thumb.
"What you want to do is focus on which companies and which investments have the power to charge through this and emerge stronger on the other side for having done so," he said.
So Fitz-Gerald said investors should look for companies with three qualities:
- They're not taking government assistance.
- They have a clear path to profits that the virus actually makes stronger.
- They have tons of cash to invest their way through this.
As for predicting a bottom, that's part of the problem we face right now.
"Bottoms are a process, not a moment in time, which means you want to think about them as something that may take a while," Fitz-Gerald said. "In the meantime, try to play offense by looking for companies with the traits I just described. Missing opportunity is always far more expensive than trying to avoid risk."
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About the Author
David Zeiler, Associate Editor for Money Morning at Money Map Press, has been a journalist for more than 35 years, including 18 spent at The Baltimore Sun. He has worked as a writer, editor, and page designer at different times in his career. He's interviewed a number of well-known personalities - ranging from punk rock icon Joey Ramone to Apple Inc. co-founder Steve Wozniak.
Over the course of his journalistic career, Dave has covered many diverse subjects. Since arriving at Money Morning in 2011, he has focused primarily on technology. He's an expert on both Apple and cryptocurrencies. He started writing about Apple for The Sun in the mid-1990s, and had an Apple blog on The Sun's web site from 2007-2009. Dave's been writing about Bitcoin since 2011 - long before most people had even heard of it. He even mined it for a short time.
Dave has a BA in English and Mass Communications from Loyola University Maryland.