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Market Commentary, May 2020

Is the Market Disconnected from Fundamentals? 

Over the past 7-8 weeks, there has been no shortage of confusion about how the market is behaving. The S&P 500 peaked around 3,385 on February 19. It then dropped to 2,235 on March 23. And it has bounced back up to 2,845 as of the time of this writing on May 13.

Many investors are wondering, “does the stock market know something we don’t?” Most are likely saying, “what the market is doing doesn’t make any sense.” At face value, there appears to be a disconnect between where the market is trading and fundamentals, such as earnings. With this backdrop of bewilderment, let us further examine the recent happenings in the economy and the financial markets.


More than 30 million people have lost their jobs since the COVID-19 epidemic took hold, and unemployment has spiked to a post-WWII high. It may be on its way to an all-time high above the peak unemployment level of the Great Depression, which is estimated to be 24.9%.

Corporate Earnings

The earnings of the companies in the S&P 500 are falling rapidly. According to FactSet:

On March 23, the forward 12-month P/E ratio was 13.1, as the price of the index hit its lowest value since 2016 at 2237.40. Since March 23, the price of the S&P 500 has increased by 28.8%, while the forward 12-month earnings per share (EPS) estimate has decreased by 16.2%. Thus, the increase in the “P” and the decrease in the “E” have both been drivers of the sharp rise in the P/E ratio over the past seven weeks. It is interesting to note that over the past 20 years, the correlation coefficient between the daily forward 12-month EPS estimate for the S&P 500 and the daily closing price of the S&P 500 is 0.92 (where 1.0 is a perfect positive linear relationship). Thus, both numbers tend to move in the same direction over time. Given the added uncertainty around estimates for future earnings due to COVID-19 (79 S&P 500 companies had withdrawn annual EPS guidance during the Q1 earnings season through April 30), this correlation may not hold in the near term. But assuming it still holds, it would seem unlikely that the increase in the price of the index and the decrease in the expected EPS for the index will continue much longer. Will the price of the index begin to fall, or will the forward 12-month EPS estimate begin to rise?

  • Earnings Scorecard: For Q1 2020 (with 86% of the companies in the S&P 500 reporting actual results), 66% of S&P 500 companies have reported a positive EPS surprise, and 58% of S&P 500 companies have reported a positive revenue surprise.
  • Earnings Growth: For Q1 2020, the blended earnings decline for the S&P 500 is -13.6%. If -13.6% is the actual decline for the quarter, it will mark the largest year-over-year decline in earnings reported by the index since Q3 2009 (-15.7%).
  • Earnings Revisions: On March 31, the estimated earnings decline for Q1 2020 was -6.9%. Four sectors have lower growth rates on May 8 (compared to March 31) due to downward revisions to EPS estimates and negative EPS surprises.
  • Earnings Guidance: For Q2 2020, 16 S&P 500 companies have issued negative EPS guidance, and 16 S&P 500 companies have issued positive EPS guidance.
  • Valuation: The forward 12-month P/E ratio for the S&P 500 is 20.4. This P/E ratio is above the 5-year average (16.7) and the 10-year average (15.1). The last time the forward 12-month P/E ratio was above 20.0 was April of 2002.

Interest Rates

The Federal Reserve has pledged to keep interest rates at or near zero for as long as necessary. As of 3/31/20, inflation is tracking around 2.1% on an annualized basis. Mortgage rates are at or very close to all-time lows, and the 10-year Treasury Bond has an annualized yield of 0.67%.

Does the Market Recovery Since March 23 Make Sense?

With this grim unemployment data and the cratering of corporate earnings, it appears to be a stretch to justify the markets rapid bounce off the (short-term?) market bottom that occurred March 23. If so many workers are unemployed and corporate earnings are expected to plummet, why and how is the stock market up 25-30% since March 23?

What if the Stock Market is Right?

The market seems to be saying the return to pre-COVID-19 conditions will happen much more quickly than most are anticipating. Additionally, public equity markets appear to be saying that the policy intervention that has occurred combined with additional, anticipated policy intervention will be enough to get the economy back on track.

Combine the Fed’s willingness to attack this crisis with everything it has (i.e., keeping interest rates near zero, buying corporate and mortgage bonds and providing stimulus to individuals and business in need), low levels of expected inflation and an expectation that corporate earnings will normalize in 2021, perhaps the current stock market valuation is not as outrageous as it appears at first glance.

Of course, the question of inflation remains to be answered. However, assuming that question is answered satisfactorily, the market does seem to be behaving more logically than initially thought. The market is pricing in earnings bouncing back in 2021 with muted inflation while the Fed continues to be very accommodative to the consumer, the general economy, and investors. Given that welcoming economic landscape, owning stocks does seem to be the sensible thing to do as stocks appear to be more attractive than other alternatives such as fixed income, cash, and even real assets (assuming inflation remains muted).

Another reason why the general market may not be as far ahead of itself as it appears is a more basic reason—the makeup of the index. In past cycles, the makeup of the index leaned more heavily towards financials and energy. Financials and energy are areas of the market where investors are historically less willing to pay a high multiple for a dollar of earnings. When looking at the current makeup of the S&P 500 index, you will see that information technology, communication services, and healthcare make up approximately 52% of the index. In contrast, financials and energy make up less than 14% of the index. This may explain the relatively high multiples from a historical standpoint.

That is to say, comparing what an investor is willing to pay for an index with a high proportion of financial and energy stocks to what an investor is willing to pay for an index with a large proportion of technology stocks is not an apt comparison. It is an especially inappropriate comparison when the index with a larger amount of financial and energy stocks is held in a high interest environment and the index with more technology stocks is being held in a near-zero interest rate environment. That would be like comparing a Ford Focus with a Tesla Model S. The average person is likely willing to pay a good bit more for the Tesla than the Ford.


As always, there are plenty of risks to the “stock market is properly pricing things” case. Sagging corporate earnings, waning investor sentiment, recovery of “temporary” job losses being less than expected, and inflation being unexpectedly higher than anticipated being some of the more worrisome hazards.

In Summary

While risks and uncertainty are always present, the range of potential financial market and economic outcomes seems to be as wide as it has ever been. The stock market recovery over the past 7+ weeks despite the lack of strong economic fundamentals means the market is seeing a future much brighter than the view that is intuitively held by people in general. Only time will tell which camp has the proper perspective on the market. At Wolf Group Capital Advisors, we will continue managing portfolios as we always have, with an eye towards rebalancing into areas of the market that have become relatively undervalued and selling areas of the market that have become relatively overvalued. While doing so, we continue to look for opportunities where we can increase the probability of market outperformance for our clients.