Earnings are Falling: What Does That Mean for the Stock Market?

The U.S. economy was in good shape heading into 2020, but the COVID-19 pandemic changed the narrative quickly. With large swaths of the economy closed for part of the first quarter, expectations for corporate earnings headed south in a hurry. How bad has it gotten? How much worse will it get, and what does this mean for the stock market?

The Numbers So Far

As I write this, 86% of S&P 500 companies have reported earnings for the first quarter of 2020. Based on reported results and projections for the companies which have yet to report, it is estimated that earnings will fall 13.6% on a year-over-year basis in the first quarter.

Looking Ahead

For the rest of the year, the situation seems like it will get worse before it gets better. Current estimates are for year-over-year drops of 40.6%, 23.0%, and 11.4% for the second, third, and fourth quarters, respectively. Not a pretty picture! What is an investor to do?

How Do Earnings Impact the Stock Market?

Earnings are very important in driving the value of companies and, by extension, the stock market in general. Looked at simplistically, growing earnings lead to increasing stock prices - so drops in earnings can conversely lead to falling stock prices. However, it is not just one year of earnings that determines the value of a company. It is the future stream of earnings – technically all future years since companies have no set expiration date.

So Where Does That Leave Us?

Unfortunately, there is no playbook for getting through the economic turbulence that we are currently experiencing. Though we get more information every day, the range of future outcomes remains quite wide. It is difficult, if not impossible, to forecast the near to intermediate-term path the economy and hence corporate earnings will take.

Earnings from 2020 will be bad. That fact is known and accepted. But since it is widely known, the market has priced it in by now. What is more important is the timing and rate of economic recovery and the implication for earnings in 2021 and beyond. No matter how bad 2020 turns out, if investors believe that the economy and corporate earnings will improve in the future, the market can go up even in the face of more bad headlines.

Going back to the Great Financial Crisis of 2008-2009, recall that the stock market bottomed in March of 2009. However, unemployment did not peak until November of that year. In other words, the economy continued to worsen for eight months after the stock market stopped going down. Why did the stock market go up while the news got worse? Because of the hope and confidence that the future would be brighter.

There is no way to know when the market will bottom. The shift from “worried about the present” to “hopeful and confident about the future” cannot be timed and will only be apparent in hindsight. We may look back and realize that the market bottomed in late March. Conversely, the bottom of the current bear market may yet be in the future. If you are investing for the long term, however, the exact timing of the bottom is not paramount to your success. As a famous investment aphorism states, time in the market is more important than the timing of the market.

Summary

The impact of the COVID-19 pandemic continues to ripple across the globe. The effect on corporate earnings is just one consequence. While the near term does not look good, the stock market is a forward-looking mechanism. It will likely adjust to reflect an improving world even before we see concrete proof of that improvement.

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