September brings a reality check for stocks2 min read . Updated: 22 Sep 2020, 09:56 PM IST
- Latest selloff has improved the balance between market performance and earnings expectations
September is living up to its well-known reputation as a poor month for stocks. Investors may grow to appreciate it.
First, there was an unraveling of bets made on technology stocks through options contracts. Now, the broader equity market has been rocked by fears about a resurgence of Covid-19 cases, as well as ongoing disagreement among U.S. lawmakers on another round of fiscal stimulus ahead of the November election.
Although indexes recovered somewhat Tuesday, the S&P 500 has fallen almost 3% over the past week, driven by shares that are directly exposed to economic growth and retail sales. The “consumer discretionary" sector is down 4%.
In part, the market could simply be making up for a period of overoptimism.
Broadly speaking, stocks this year have moved roughly in line with earnings expectations, despite the chaos unleashed by the pandemic and the apparent disconnect between equities’ exuberance and the economy’s woes. According to FactSet data, changes in firms’ market value since Jan. 31 show a strong positive correlation with changes in analysts’ profit forecasts, which are in turn based chiefly on guidance given by executives.
The link is stronger when it comes to 2022 earnings expectations, showing that investors’ optimism is founded on visions of the post-Covid future. But it remains robust even when looking at nearer-term predictions, which tend to be more accurate.
Gains in U.S. stocks have been driven by earnings-per-share figures being revised upwards, especially relative to the rest of the world. But this effect may have run its course: Revisions have recently overshot improvements in economic indicators like the ISM index, JPMorgan strategist Mislav Matejka highlighted this week, and seem to have peaked for now.
Also, there are still gaps between market value and earnings in some industries. Utilities, for example, have had a dismal year, even though analysts only expect a small dent to their 2022 operating profits. On the flip side, sectors like tech and consumer discretionary have risen in value despite expectations that the pandemic will hit their earnings.
Most of the analysis has focused on gauging whether Silicon Valley giants are overvalued, since they have given wings to the market rally. But these companies are at least long-term structural winners from purchases shifting online, which makes them a hedge against an uncertain world.
Questions about valuation seem even more pertinent for consumer-focused shares. Their gains can partly be explained by the inclusion of online giant Amazon.com in the category, but the likes of Nike, Victoria’s Secret-owner L Brands and McDonald’s also show up as overvalued. Importantly, this industry is fully exposed to today’s economic uncertainty, meaning earnings expectations are at greater risk of downgrades.
Overall, investors can take some solace from a market that, with some notable exceptions, has kept in touch with corporate news. But a 1.7% rise in the S&P 500 during the worst one-off economic hit in recent history still merits some soul-searching as to whether the rally has gone too far, given the unusual risks to which some sectors’ earnings estimates are subject to right now.
This month’s setback could be a cheap price to pay to keep the market grounded.