Equity Valuations in Volatile Markets | Lord Abbett
Image alt tag

Error!

There was a problem contacting the server. Please try after sometime.

Sorry, we are unable to process your request.

Error!

We're sorry, but the Insights and Intelligence Tool is temporarily unavailable

If this problem persists, or if you need immediate assistance, please contact Customer Service at 1-888-522-2388.

Error!

We're sorry, but the Literature Center checkout function is temporarily unavailable.

If this problem persists, or if you need immediate assistance, please contact Customer Service at 1-888-522-2388.

Tracked Funds

You have 0 funds on your mutual fund watch list.

Begin by selecting funds to create a personalized watch list.

(as of 12/05/2015)

Pending Orders

You have 0 items in your cart.

Subscribe and order forms, fact sheets, presentations, and other documents that can help advisers grow their business.

Reset Your Password

Financial Professionals*

Your password must be a minimum of characters.

Confirmation Message

Your LordAbbett.com password was successully updated. This page will be refreshed after 3 seconds.

OK

 

Institutional Perspectives

Notwithstanding recent volatility, a check on long-term fundamentals shows some support for current valuations.

Read time: 5 minutes

With the S&P 500® Index up sharply since bottoming on March 23, some investors have begun to wonder if the U.S. market has become overvalued and is due for a correction. (Indeed, a bout of renewed volatility that began on September 3 may indicate some growing trepidation.) In addition, a number of observers believe corporate earnings may not soon fully recover, given the continuing effect of the pandemic on economic activity.

We believe these concerns need to be placed into context. Here, we examine three factors which suggest that this market may still be on solid footing, incorporating insights from Lord Abbett Partner and Director of Strategic Asset Allocation Giulio Martini.   

Reason 1: The Market May Be Looking Beyond Current Earnings

As of August 25, the forward price-to-earnings (P/E) ratio on the S&P 500 had reached 21.9, its highest level since the tech boom in the late 1990s. But investors may be viewing recent weakness in earnings as temporary and instead valuing stocks on the basis of normalized earnings, which attempt to smooth out the effects of cyclicality by using estimates based on a statistical filter whose fit, we believe happens to be extremely robust,. This matters because the U.S. market seems quite pricey when valued on the basis of near-term earnings expectations but is not pricey at all, in our view, when compared to estimated normalized earnings. Figure 1 shows that, based on the latter, the P/E ratio is far below the peak reached in the height of the tech boom.

 

Figure 1. In Relation to Normalized Earnings, Stocks Do Not Appear Expensive

Price-to-normalized earnings ratio for the S&P 500 (monthly), June 1955–August 2020

Source: Bloomberg. Data as of September 3, 2020. Normalized earnings per share are calculated using a 10-year average of trailing-four-quarter earnings per share.
The historical data are for illustrative purposes only, do not represent the performance of any specific portfolio managed by Lord Abbett or any particular investment, and are not intended to predict or depict future results. Due to market volatility, the market may not perform in a similar manner in the future. Past performance is not a reliable indicator or guarantee of future results.

 

Reason 2: Earnings Weakness Has Been Narrow, Suggesting a Quick Recovery Is Likely

While overall earnings are currently depressed, we see only modest setbacks among most companies. More than three-quarters of the earnings decline in the S&P 500 has been due to losses in airlines and travel-related sectors, in the banking industry, and in the energy sector. Airlines and travel-related companies, more than most others, have borne the brunt of pandemic-related shutdowns, while banks have been hurt by having to provision for potential future losses. In the energy sector, companies continue to struggle with low prices due to low demand attributable to the pandemic. In short, once the economy overcomes the effects of the COVID-19 virus, either through the development of a vaccine and effective therapeutic treatments or through adaptations such as tactics employed by countries that have successfully contained viral spread, earnings have the potential to bounce back to the previous trend.

The rest of the economy accounts for just under a quarter of the corporate earnings decline. In those industries, companies have managed to maintain earnings surprisingly well considering the magnitude of the downturn in GDP by cutting working capital, curtailing capital spending, and reducing labor costs. Thus, while second-quarter gross domestic product (GDP) plunged about 32% on an annualized basis, there has not yet been any appreciable damage to long-term earnings power.   

This suggests that although current earnings are depressed, the potential for a bounce-back is probably greater than appreciated. A similar narrow decline in earnings occurred after the 2008–09 Global Financial Crisis (GFC), and earnings rapidly returned to, and even exceeded, the normalized level. In part, this was because the concentration of losses in the financial sector was even greater during the GFC because regulators imposed draconian provisioning requirements on banks.

 

Figure 2. With Losses Confined to a Few Sectors, U.S. Corporate Earnings Could Bounce Back Quickly

Actual and normalized earnings for the S&P 500 index (monthly), June 1955–August 2020

Source: Bloomberg. Data as of September 3, 2020. Normalized earnings per share are calculated using a 10-year average of trailing-four-quarter earnings per share.
The historical data are for illustrative purposes only, do not represent the performance of any specific portfolio managed by Lord Abbett or any particular investment, and are not intended to predict or depict future results. Due to market volatility, the market may not perform in a similar manner in the future. Past performance is not a reliable indicator or guarantee of future results.

 

Another factor working in favor of a quick recovery is U.S. labor productivity. Unlike during most previous economic downturns, productivity growth accelerated in the first and second quarters of 2020. Thus, whereas companies usually hoard labor during downturns in order to get a leg up when the economy recovers, that didn’t happen this time around. This would help explain a more rapid and sharper recovery than usual in employment if that continues to play out. It also helps explain why earnings and margins held up much better than expected in the second quarter.

Reason 3: U.S. Earnings Are Recovering More Quickly than those in Other Markets

As of August 28, 98% of the companies in the S&P 500 had reported earnings for the second quarter, according to FactSet, and of these, 84% beat the mean earnings estimate. This is significantly higher than the five-year trailing average of 72%.

In fact, this was the highest percentage for a quarter since FactSet began tracking the data in the third quarter of 2008. Among sectors, Information Technology (94%), Materials (93%), Health Care (92%), and Industrials (92%) had the most companies beating estimates.

Altogether, second-quarter reported earnings on the S&P 500 were 23.1% above expectations, far above the trailing five-year average of 4.7%. Sectors with the biggest earnings beats were Consumer Discretionary (542.6%) and Industrials (78.9%). (FactSet notes that second-quarter earnings estimates had been lowered significantly prior to the second-quarter earnings season.)

 

Figure 3. The Size of Earnings Surprises Soared in the 2020 Second Quarter

S&P 500 earnings surprises, Q3 2015–Q2 2020

Source: FactSet. Data as of September 3, 2020. Earnings surprise measures the percentage of companies reporting actual earnings per share above analyst estimates.

The historical data are for illustrative purposes only, do not represent the performance of any specific portfolio managed by Lord Abbett or any particular investment, and are not intended to predict or depict future results. Due to market volatility, the market may not perform in a similar manner in the future. Past performance is not a reliable indicator or guarantee of future results.

 

These results have contributed to earnings momentum. This measure of the magnitude of analyst revisions to earnings estimates also suggests continued strength for U.S. equity markets versus those in other countries. Based on the three-month moving average of revisions to the consensus earnings estimates, earnings momentum for U.S. companies is greater than that occurring in the rest of the world. In our view, this may be a potential justification for at least a portion of the wide valuation premium that is currently being accorded to U.S. stocks.
 

Figure 4. U.S. Earnings Momentum Exceeds that in Other Markets

U.S. earnings momentum (current fiscal year) versus world equities, January 1994–August 2020

Source: FactSet. Data as of September 3, 2020. Earnings momentum measures of the magnitude of analyst revisions to earnings estimates.
The historical data are for illustrative purposes only, do not represent the performance of any specific portfolio managed by Lord Abbett or any particular investment, and are not intended to predict or depict future results. Due to market volatility, the market may not perform in a similar manner in the future. Past performance is not a reliable indicator or guarantee of future results.

 

Summing Up

While recent headlines suggest that U.S. equities markets are overvalued, a closer look indicates that may be a bit of an exaggeration. Investors appear to be viewing the second quarter’s earnings decline as temporary. In fact, with most losses confined to certain industries, the narrow nature of the decline suggests that a rebound could happen quickly, much as it did after the GFC. In addition, the number of second-quarter earnings reports that exceeded expectations and the size of the earnings beat (albeit off a reduced base) have led analysts to raise their expectations for 2021. Finally, earnings momentum, and the magnitude of analyst earnings revisions, is outpacing that in other markets, suggesting that higher valuations on U.S. equities are merited.

 

A Note about Risk: The value of investments in equity securities will fluctuate in response to general economic conditions and to changes in the prospects of particular companies and/or sectors in the economy. While growth stocks are subject to the daily ups and downs of the stock market, their long-term potential as well as their volatility can be substantial. Value investing involves the risk that the market may not recognize that securities are undervalued, and they may not appreciate as anticipated. Smaller companies tend to be more volatile and less liquid than larger companies. Small cap companies may also have more limited product lines, markets, or financial resources and typically experience a higher risk of failure than large cap companies.

The information provided is for general informational purposes only. References to any specific securities, sectors or investment themes are for illustrative purposes only and should not be considered an individualized recommendation or personalized investment advice, and should not be used as the basis for any investment decision. This is not a representation of any securities Lord Abbett purchased or would have purchased or that an investment in any securities of such issuers would be profitable. Statements concerning financial market trends are based on current market conditions, which will fluctuate. There is no guarantee that markets will perform in a similar manner under similar conditions in the future. Past performance is not a reliable indicator of future results.

Forecasts and projections are based on current market conditions and are subject to change without notice. Projections should not be considered a guarantee.

This Market View may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.

The forward P/E ratio is a current stock's price over its "predicted" earnings per share.

The S&P 500® Index is widely regarded as the standard for measuring large cap U.S. stock market performance and includes a representative sample of leading companies in leading industries.

Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

The information provided herein is not directed at any investor or category of investors and is provided solely as general information about our products and services and to otherwise provide general investment education.  No information contained herein should be regarded as a suggestion to engage in or refrain from any investment-related course of action as Lord, Abbett & Co LLC (and its affiliates, “Lord Abbett”) is not undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity with respect to the materials presented herein.   If you are an individual retirement investor, contact your financial advisor or other non-Lord Abbett fiduciary about whether any given investment idea, strategy, product, or service described herein may be appropriate for your circumstances.

The opinions in Market View are as of the date of publication and are subject to change. Additionally, the opinions may not represent the opinions of the firm as a whole. The document is not intended for use as forecast, research or investment advice concerning any particular investment or the markets in general, and it is not intended to be legal advice or tax advice. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information.

image

Please confirm your literature shipping address

Please review the address information below and make any necessary changes.

All literature orders will be shipped to the address that you enter below. This information can be edited at any time.

Current Literature Shipping Address

* Required field