Can Investors Trust the Stock Market Rally?

Can Investors Trust the Stock Market Rally?

Less than a month ago, the stock market was in free fall, as a torrent of bad news about the coronavirus pandemic and its economic fallout drove investors to dump stocks. Just as swiftly, the market has rebounded, even as millions of people lose their jobs every week and the country is destined for a recession.

Can the rally be trusted?

The word on Wall Street is a tentative yes. More people are embracing the idea that stocks have “bottomed” — investor parlance for the lowest the market will go — and won’t fall below the depths they reached on March 23, when the S&P 500 stock index was 34 percent below its high from just over a month earlier.

Don’t celebrate just yet: Even if they don’t anticipate another sharp plunge, most observers hardly expect the market to soar, either. Investors who are wading back into the water are getting confusing signals: Quarterly earnings are shrinking and corporate reports provide few clues about the future, while rising stock prices are hard to square with the mounting toll of an unprecedented economic collapse.

What’s more, the combination of rising shares and reduced profits is making the market looking incredibly expensive, according to a metric widely used by investors to value the market, the price-to-earnings ratio.

“Right now you’re kind of in this no man’s land, purgatory,” said Brian Belski, chief investment strategist with BMO Capital Markets. “Earnings aren’t going to give you the answer. The economy’s certainly not going to give you the answer. They’re byproducts of the pandemic.”

If there’s one thing analysts and investors agree on, it’s that neither the optimists nor the pessimists are firmly in control of the market’s direction at the moment. That’s because the path of the coronavirus crisis is impossible to predict.

Initially, as the outbreak spread across the country, forcing local governments to shut down economies and people to stay at home, the market’s reaction was unanimous. Starting in late-February, trading turned highly volatile, leading the S&P 500 to its steepest drop into a bear market since 1933. By the time the market hit what many now believe was rock bottom on March 23, the plunge had incinerated almost $10 trillion in wealth and ended an 11-year bull run.

Just as suddenly, stocks staged an about-face in the last week of March, after the Federal Reserve announced plans to pump trillions of dollars of new money into the markets and Congress passed a $2 trillion economic rescue package. The announcements — along with some signs of early success in “flattening the curve” of the outbreak in New York — set off a remarkable rally of more than 25 percent, catching many investors off-guard and helping the S&P 500 reclaim more than half its previous losses.

In recent days, though, stocks have settled into a middle zone: far from the low levels that clearly signaled a bear market, but not conclusively blossoming into a new bull market either.

“You could almost argue that we’re in a bull market and a bear market at the same time,” said Eddie Perkin, the chief equity investment officer at Eaton Vance, a Boston-based money manager.

On Monday, stocks were down more than 1 percent in early trading, led by a sell-off in energy shares.

While investors might be tempted to buy stocks now, before the market starts surging higher, many of them are torn. That’s because the recent stock market rally combined with the ongoing the pandemic has pushed price-to-earnings ratios incredibly high. It’s no overstatement to say the market is currently the most highly valued it has been in almost two decades, just as the country plummets into what’s expected to be the deepest recession since the Great Depression.

Typically, investors calculate a stock’s value by comparing the price of a share to its earnings. The higher the ratio, the more expensive the stock is considered. The calculation can be applied to all 500 companies in the index to assess whether the market as a whole is overvalued or undervalued.

When investors are optimistic about future earnings, they’re more willing to pay higher prices for expected earnings, generating a higher price-to-earnings ratio — sometimes just called the P/E ratio. When they’re pessimistic, they’re less likely to pay a lot for the earnings that have been forecast, in part because they’re skeptical those earnings will actually be produced. That typically results in a low P/E ratio.

When the market collapsed last month, P/E ratio plummeted. But it began rising in recent weeks, and could climb further if the market merely remains steady.

The reason: Public companies are beginning to report their first quarter results. Many will report drastically reduced earnings, with profit expectations for the rest of the year looking grim.

At the end of March, analysts were expecting earnings for S&P 500 companies to be down 10.5 percent in the second quarter, which ends in June. As of Friday, they had updated their expectations and now think profits will fall more than 25 percent, according to FactSet data.

With earnings shrinking and stock prices generally stable, the ratio between the two will rise, making stocks look more expensive and potentially making the market rally more precarious. (Highly valued markets often suffer some of the most violent pullbacks.)

That leaves investors in a state of limbo, watching a rally that is difficult to make sense of because of how bleak the future looks.

In other words, while the market is making money, it is churning out a lot of confusion too.

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