In the wake of the best quarter for stocks in more than 20 years, clients are asking us about current opportunities and risks. The economy is in recession and corporate earnings fell precipitously during the second quarter. Yet, the market has nearly rallied all the way back from the pandemic-induced bear market.
As a result, stocks are expensive relative to historical and future growth forecasts. From a company perspective, we believe the stocks likely to perform best are those of high-quality, low-debt businesses with experienced management teams generating enduring profit growth. For investors, we think it’s reasonable to expect continued market volatility in the face of enormous uncertainty. And we believe the best approach is to look beyond short-term earnings fluctuations and focus instead on businesses able to generate attractive cash flow growth over a long horizon.
The coronavirus and steps to combat it have taken a tremendous toll on the earnings power of corporate America. First-quarter earnings of the S&P 500® Index declined by approximately 14% quarter over quarter, according to FactSet. That was the largest year-over-year decline since the third quarter of 2009, which coincided with the unemployment peak in the wake of the Great Recession. What’s more, second-quarter corporate earnings are down more than 40% with roughly one-quarter of the companies in the S&P 500 reporting as of this writing.
At the market’s record high in February, the S&P 500 stood just short of 3400, with a price that was 19 times the then-forward earnings estimate. Today in late July, the market stands at 3200. But after the big earnings decline, the Index’s forward P/E ratio is now greater than 22 times. The last time the forward P/E reached 22 was 20 years ago in May 2001, according to FactSet. For context, the average forward P/E on the S&P 500 over the last 10 years is 15.1.
It’s not unheard of for stock prices and earnings to move in different directions—prices often peak or trough before earnings do so. But the market is betting heavily on a sharp recovery not yet evident in the data. Equity investors are assuming a V-shaped economic rebound, rather than the more protracted U- or L-shaped scenarios that push recovery in growth and earnings further into the future. Said differently, investors are acting as if there are clear periods pre- and post-COVID. However, we believe the virus will be with us and influencing consumer behavior for some time to come.
What’s filling the earnings gap and propping up stocks in the meantime? We believe massive monetary and fiscal stimulus are supporting asset prices in the near term. It’s no coincidence the stock market bottomed on March 23, the same day the Federal Reserve (Fed) pledged to pull out all the stops to support the economy and financial markets. In the Fed’s own words, it is “committed to using its full range of tools to support households, businesses, and the U.S. economy,” as well as “support for critical market functioning.” Congress, too, has taken aggressive steps to boost the economy, authorizing $2.5 trillion in spending between March and April. These actions mean that measures of federal debt to GDP and the budget deficit to GDP may well reach all-time highs, or the highest levels since World War II.
This raises the larger issue of debt throughout the economy—not just government debt but also that held by consumers and corporations. We find the stock market sell-off was most pronounced in companies, industries and sectors carrying the greatest leverage. In contrast, the stocks that held up best tended to be those with healthy balance sheets. This make sense because how companies manage their balance sheets helps determine winners and losers in almost any business over time. In good times, businesses can finance their debts and sustain operations by raising capital from financial markets. This has been doubly true since the 2008-2009 financial crisis—we enjoyed one of the longest economic and market expansions on record while interest rates were at historically low levels.
In recent years, record-low interest rates meant companies have been eager to take on debt to fund share buybacks and their business plans. But many of these companies were the first victims in the February-March bear market, when financial conditions tightened and it became more difficult to service previously tame debt costs.
The fundamental premise of the V-shaped recovery provides a clear break—periods before and after the outbreak. We don’t possess any special knowledge of the virus but think the post-COVID premise is debatable. Infection rate data we’re seeing across the United States and Central and South America doesn’t support the notion of a rapid resolution to the economic crisis. Of course, economic outcomes are partly dependent on the progress of the disease and steps to mitigate it. Because we don’t foresee a quick resolution of the virus, we expect a gradual economic recovery rather than a rapid snapback.
It also seems likely that we will see behavioral changes across many dimensions of society and the economy, including consumption, social, labor and lifestyle. High levels of unemployment and corporate bankruptcies will likely complicate the recovery as well. For these reasons, we think it will take much longer for growth and earnings to normalize.
Given this potentially prolonged hit to economic growth, the question becomes where to invest now? Fundamentally, we believe a long-term focus is essential. Companies with solid long-term growth prospects are better situated to ride out the downturn. Business conditions vary quarter to quarter and year to year. And stocks go up or down in the near term for any number of reasons. That’s why we prefer to evaluate companies over a longer horizon, like three to five years rather than three to five months. Ultimately, we think the companies most likely to succeed are those with enduring franchises and strong balance sheets. Furthermore, the uncertain environment argues for high-quality companies with experienced management teams. Said differently, we think your positioning should be determined by an assessment of a company’s long-term business conditions and faith in management to execute on those opportunities.
We believe it’s preferable to focus on companies whose earnings growth is driven by innovation and industry disruption. Contrast this with companies whose earnings are heavily dependent on growth in the broader economy. And while we don’t invest thematically, it’s possible to identify strong secular growth themes among the individual companies in our portfolios. These include:
While resolution of the pandemic is unclear, it seems likely the disease and its aftereffects will be with us for some time. If that’s correct, then we think markets will likely be volatile and characterized by uncertainty for the foreseeable future. That should reward innovative, secular growth companies over those dependent on the economic cycle to generate earnings growth. We see many such growth opportunities in the technology, health care and financial sectors, among others. In addition, we believe high-quality companies with healthy balance sheets and attractive cash flow growth should outperform those with excessive debt and/or that are unable to finance their operations. We aren’t arguing that “it’s different this time.” Rather, we think investors who do well use some of the most tried-and-tested investment tools—focusing on sustainable corporate earnings growth, management’s use of resulting cash flows and the price investors pay for the earnings they are buying.
The opinions expressed are those of American Century Investments (or the portfolio manager) and are no guarantee of the future performance of any American Century Investments' portfolio. This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.
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