In their latest feat of levitation, U.S. stocks are about to pull off their biggest earnings-season rally in six years.
Impressive — or ridiculous, depending on your view — considering it happened as American companies were reporting a 16% profit drop that was the worst since the financial crisis. Since firms started disclosing results, the S&P 500 has jumped 6%, the most at this point of the cycle since 2014, and the second-most since 2009. It climbed 3.5% this week, extending a gain from March to 30% and pushing Amazon.com Inc. and Netflix Inc. to records.
Suddenly, a rally the experts insisted bore every hallmark of being doomed is starting to resemble the kind of advance that proves permanent. While 20% surges that quickly reverse are common in bear markets, 30% gains have only fallen apart twice: both in the 1929-1932 era, according to Leuthold’s Doug Ramsey. Of the 22 previous cyclical bear markets over the past 120 years, all but one could have been “declared dead” when gains topped 30%, he wrote in a report.
“That’s what the percentage-gain would say, that the odds are skewed in favor of it being a bull market just by virtue of the size of the move,” said Ramsey, the firm’s chief investment officer. “But it’s not normal.”
Should the March 23 low hold, the 33-day, 34% decline from the February peak would mark the shortest bear market on record.
While fortress-like tech gets all the press, evidence is building that another trusted companion of bulls, the Federal Reserve, is the real reason for the progress. At a time when demand is evaporating as millions of workers lose jobs and bankruptcies multiply, companies with the diciest credit won’t stop climbing in the stock market. Small caps just strung together a third week of gains and companies with the most default risk are beating those with the best credit health by a factor of five over the period.
All this as the economy heads for what’s likely to be the deepest recession in at least eight decades, when more than a third of S&P 500 companies have withdrawn financial guidance, and buybacks and dividends are shrinking by billions of dollars.
The Fed’s hand is visible at every inflection point. Days after it accelerated bond purchases in mid-March, the equity benchmark halted a five-week, 34% plunge. When the Fed announced plans to buy bond ETFs in early April, stocks gathered additional steam, with companies with shaky finances or those hit most by the pandemic — such as energy and retailers — leading the charge.
“I bat my eyes whenever I hear someone ask, ‘Is the Fed out of ammo?’ They’ve never been out of ammo and they’re certainly not out of ammo now,” said Lauren Goodwin, economist and multi-asset portfolio strategist at New York Life Investments. “The interpretation that we could see further support for risk assets is not necessarily going to happen, but the possibility is correct. That has all kinds of implications we’re thinking about, but that’s contributing to the rally.”
As for the impact on earnings season, consider a model developed by Bank of America, tracking the S&P 500’s price-earnings ratios at times like now, when earnings are all but impossible to predict. Historically, the more uncertainty there is over future profits, the less investors are willing to pay for stocks, strategists led by Benjamin Bowler found.
Currently, that’s not the case. Confusion about what companies will report right now is more pronounced than it has been at any time since the financial crisis. But at 22 times forecast profits, the S&P 500 is trading at a multiple not seen since the dot-com bubble.
“Equities are either betting on a record short recession (despite forecasts for near the worst in history), or on the Fed buying equities, believing fundamentals don’t matter,” Bowler wrote in a note earlier this week. “There may be a time to co-invest in equities with the Fed, but it will surely be at lower prices.”
That idea — that after a $2 trillion rally the Fed will buy stocks — strikes many people as a little nuts. For one, it would require a change to the Federal Reserve Act.
“It’s a dangerous game,” said Chris Gaffney, president of world markets at TIAA. “You don’t fight the Fed, but trying to predict what’s going to happen is dangerous especially when you’re betting on something that’s never been done.”
Fed Chairman Jerome Powell has little appetite to dip into equities directly and might instead punt the burden to Congress, he said.
But not everyone’s writing off the possibility. According to Vincent Deluard, global macro strategist at INTL FCStone, it’s likely the Fed will eventually have to step into the stock market. Cash-strapped companies moving away from buybacks will leave a permanent $500 billion-plus gap in the equity supply and demand picture, he says, and aging demographics also means less stock buying.
“I only see one possible actor, and that’s the Fed. I’m sure it’s there, but it’s there at a lower price point,” Deluard said. “What Goes Up” podcast. “Nothing surprises me anymore, but it would surprise me if 10% below the all-time high the Fed says, ‘OK, you know what we’ve got to do? Buy stocks.”’ Still, he added, “This is how this ends, because of that supply and demand factor.”
In the absence of something like that, does any valuation case justify stocks at these heights? One may, though rarely has it been more controversial — the methodology sometimes called the Fed model that compares corporate profits to bond yields. By that measure, the S&P 500’s earnings yield — how much profits you get relative to share prices — is more than 4 percentage points above payouts on 10-year Treasuries. All things being equal, it shows that shares are better priced than 92% of the time since 1990.
The advantage in relative value is one big bull case for strategists such as JPMorgan’s Marko Kolanovic. “We estimate the impact of Fed easing in both rates and credit more than compensate for the temporary hit to corporate earnings when valuing the U.S. market via discounted earnings,” Kolanovic wrote in a Thursday note. His team advised investors to favor risky assets such as credit and stocks, saying the S&P 500 is likely to reach an all-time high in the first half of 2021.
— With assistance by Sarah Ponczek, and Elena Popina