The Outlook for U.S. Stocks – It’s All Relative

The Monthly Five Author Avator

Katie Nixon, CFA, CPWA®, CIMA®

Chief Investment Officer, Northern Trust Wealth Management

May 21, 2020

COVID-19 Crisis Special Edition:
Your Questions Answered

We hosted our weekly Insights call on Tuesday, and many of the questions we received revolved around our outlook for U.S. stocks, with a particular focus on their significant bounce from March lows. To help answer these questions, we spent some time digging into this topic with our head of fundamental equities, Chris Shipley. Below are answers to five questions we discussed with him.


Why have equities recovered so much – the economic data continues to look terrible!

  • Progress on the virus: We continue to see curve flattening in the “hot spots” and observe much higher testing numbers, which has been widely reported as a requirement for confidently relaxing lockdown measures. Further, investors have watched advancements on the treatment and vaccine fronts, both of which have received intense focus from the pharma/biotech industry and exhibited progress. For example, the announcement that Moderna’s vaccine has shown early indications of viability has certainly fed into optimism.
  • We have a plan!: Currently, all 50 states are in the process of relaxing lockdown measures, and investors are getting real-time updates as to the impact this is having on local economies and some large businesses. There are signs of pent up demand; for example, Starbucks reporting that it has recovered 60-65% of same-store sales over the last week. As we have noted in the past, each day brings new data and can provide important signals about the expected contours of the recovery.
  • The bridge has been built: We continue to hear from Treasury Secretary Mnuchin and Federal Reserve Chairman Powell that policymakers remain very much on the case, ready to provide more support if needed. Powell, in particular, has struck a cautious tone both in a 60 Minutes interview last Sunday as well as through the recently released Federal Open Market Committee minutes, and acknowledges that more will likely be needed. This stance is important for investors, as aggressive and targeted policy mitigates a key risk case.

Can the large tech stocks continue to lead the market?

In short, yes, but valuation may be a limitation to how far they can run. These companies have revealed themselves to have strong secular tailwinds, fortress balance sheets and business models that are both flexible and resilient. This has not gone unnoticed, of course. The top five stocks in the S&P 500 (Apple, Google/Alphabet, Microsoft, Amazon and Facebook) have led the market in terms of return and have an aggregate forward price to earnings multiple of 26 times 2021 estimates.

While we know that valuations are a very poor market timing tool, they do tell us that there is a lot of good news baked into investor expectations. We also know that, longer term, high valuations suggest lower long-term returns. This makes sense: High valuations reflect abundant confidence and an assessment by investors that these companies are more stable/lower risk. Risk and reward are related, so lower risk can drive lower returns.

Also, there is another current tailwind to these top five behemoths; these are growth stocks, and in the absence of overall economic growth, investors will pay a high price for growth. This condition may change if we start to see an inflection in overall economic growth. If and when we see not just stability but actual growth in the U.S./global economy, investors may shift their focus to companies with the highest sensitivity to recovery: smaller-cap companies and those in the financial, industrial and energy sectors. We have started to see a nascent shift into those areas over the past few weeks, and this trend is something we will continue to monitor.


Won’t bank earnings get hit hard when we start to see bankruptcies amid persistently high unemployment? Will this threaten the financial system?

The good news here is that, in the U.S., we have strong regulatory oversight, and overall, a strong capital liquidity position. One of the big differentiators coming out of the Global Financial Crisis (GFC) for U.S. banks relative to Europe, for example, was that our banks raised capital and took the related pain, thereby enabling them to participate in and contribute to the post GFC recovery. Significant changes to bank regulation came out of that crisis, including strict capital requirements and stress tests.

Today, U.S. banks have lots of capital and liquidity. First, they have improved their own liquidity profiles, and second, the Fed has gotten much better at addressing liquidity issues in the market, as evidenced by its decisive intervention during the COVID-19 crisis. On the regulatory front, a recently imposed rule, the Current Expected Credit Loss (CECL), requires banks to estimate credit losses over the life of loans and book those reserves up front. We saw this hit bank earnings in the first quarter and expect a more acute hit in the second quarter. That said, and looking forward, banks may have taken all necessary reserves by the end of the third quarter. All in all, banks are in a much better position to face this sharp economic downturn.


Will companies stop buying back their stock this year, and won’t that crimp returns for shareholders?

It is certainly true that stock buybacks have been an earnings tailwind, boosting earnings per share over the past several years. Last year, share buybacks increased earnings per-share by 2%, for example. Amid the COVID-19 crisis, however, buyback activity is widely expected to wane – perhaps significantly.

There are two driving forces behind this: First, regulators and policymakers have cast some aspersions on companies who have committed to stock buybacks as the economy has weakened significantly and have challenged companies to commit to helping employees over shareholders. Second, and more importantly, companies are expressing a new preference for liquidity, keeping cash on their balance sheets and trying to avoid using cash flow or debt to fund share buybacks. As a result, we see one-third of announced buyback activity being suspended.

So will this impact earnings per share? The simple answer is yes, but it probably won’t matter much given the expected earnings decline this year.


Is there any good news coming out of this earnings season?

In what will become a recurring theme, we would say “It’s All Relative.” While companies remain extremely reluctant to provide forward guidance, it is incredibly difficult to forecast with confidence. First quarter results were weak, overall, with earnings for the S&P 500 expected to fall. Our fundamental research team has a full-year 2020 S&P 500 earnings estimate of $130 per share, against the $163 per share earned in 2019. We don’t expect earnings to recover fully until 2021 at the earliest.

Interestingly, the first quarter really only had a few weeks that were drastically impacted by the nationwide lockdown, so we expect second quarter results to be much weaker, reflecting decline in economic activity in April and much of May. That said, we did hear from some companies that reported late in the season and hence had a view on how business was doing as cities and towns relax lockdowns. And they reported seeing some green shoots of demand. High frequency data remained weak but did show an inflection point, which supports the premise that we will see pent up demand manifest in better activity going forward.

It is early days, and we will continue to monitor this data to inform not only our evolving forecast, but also to illuminate characteristics of this “new normal” economy.


This information is not intended to be and should not be treated as legal, investment, accounting or tax advice and is for informational purposes only. Readers, including professionals, should under no circumstances rely upon this information as a substitute for their own research or for obtaining specific legal, accounting or tax advice from their own counsel. All information discussed herein is current only as of the date appearing in this material and is subject to change at any time without notice.

The information contained herein, including any information regarding specific investment products or strategies, is provided for informational and/or illustrative purposes only, and is not intended to be and should not be construed as an offer, solicitation or recommendation with respect to any investment transaction, product or strategy. Past performance is no guarantee of future results. All material has been obtained from sources believed to be reliable, but its accuracy, completeness and interpretation cannot be guaranteed.