Earnings, Economics Will Drive Stock Returns From Here
Investors' focus has shifted this week to earnings reports and economic metrics in order to decipher how quickly a recovery can evolve.
|Editor's note: Read the latest on how the coronavirus is rattling the markets and what investors can do to navigate it.|
Since hitting its recent lows on March 23, 2020, U.S. equity markets have rebounded 25% and gained back half of their losses from their February highs. Over this same time period, Morningstar's Market Fair Value has risen to 0.89 from its more-than-decade-long low of 0.70 on March 23, at which time our fair value metric was at its lowest level since 2009. This metric reflects the ratio of a company's stock price to our fair value estimate for the median stock in our coverage universe. As we noted in "Time to Take a Breath and Re-Evaluate," when our median price/fair value metric has dropped into this range, this greater-than-usual margin of safety as compared with our fair value estimates has indicated that the equity market has probably overreacted to the downside, and this represents a good entry point for long-term investors. While we continue to see a significant number of opportunities for long-term investors, much of the easy short-term returns have been made.
Investors have shifted their attention away from evaluating the potential economic impact of the monetary and fiscal stimulus plans announced over the past few weeks and toward earnings--where we will get our first glimpse at how much of an impact the shutdown has had on companies. In addition, we are just now starting to see the release of economic indicators for March that reveal the depth of economic disruption. While coronavirus-related headlines will continue to impact the daily movements of the stock market, the longer-term trend will be driven by earnings and the economy. Investors are not only looking to analyze the depths of earnings deterioration in the near term, but more importantly they are evaluating the time frames for an economic recovery and an earnings rebound toward normalized levels.
Higher Loan-Loss Reserves Already Incorporated in Our Fair Value Estimates
Most of the large banks reported shaky first-quarter results this week, sending their share prices down since earnings were released. In preparation for the expected onslaught of consumer and corporate defaults, the banks have begun to build their loan-loss reserves. For example, JPMorgan Chase (JPM) increased its loss reserves by $6.8 billion in the first quarter versus less than $6.0 billion in all of 2019. In addition, we expect that JPMorgan will have to further increase its loan-loss reserves in the second quarter by 20% to approximately $8.2 billion, and we forecast the bank will report total loan-loss reserves of $25 billion for full-year 2020. At that level, loan-loss reserves would be about 2.5% of the bank's total loans. We expect a similar story across the banking sector as first-quarter results continue to unfold. In our view, banks will need to continue to build loss reserves to cover expected charge-offs as the impending recession takes its toll on individuals and businesses. However, even after incorporating heightened expectations for charge-offs, we continue to see value in the banking sector. Most of the large banks under our coverage have Morningstar Ratings of 4 stars, but we see even better value in regional banks such as Fifth Third (FITB), Huntington Bancshares (HBAN), and KeyCorp (KEY); each is rated 5 stars. For additional investment ideas across our coverage universe, please see "32 Undervalued Stocks," which provides a list of our analysts' top ideas in each sector.
Economic Activity Plunging, but There's Long-Term Value in Many of the Hardest-Hit Sectors
Among economic indicators released this week, both the retail sales and industrial production reports showed a sharp downturn in March and presage an even greater decline in April. Seasonally adjusted retail sales declined 8.7% in March compared with February and declined 6.2% compared with March 2019. Considering that the bulk of the shut-in orders began in mid-March, we fully expect that the April report will reflect an even greater decline in retail sales both on a sequential and year-over-year basis. There was a wide divergence in sales among categories. For example, grocery store sales soared 25.6% and health and beauty care store sales rose 4.3% as consumers prepared to stay at home, whereas restaurant sales declined 26.5%. Even after incorporating significant sales slowdowns in the near term across the restaurant sector, we believe that stock prices have fallen further than our long-term view warrants. For example, companies that we rate with a wide Morningstar Economic Moat Rating such as McDonald's (MCD) and Starbucks (SBUX) are rated 4 stars based on their current stock prices. Both general merchandise and nonstore retailers fared well with sales increases of 6.4% and 3.1%, respectively, and building materials rose 1.3%. However, among the other large categories, auto sales declined 25.6%, gasoline sales fell 17.2%, and clothing plummeted 50.5%. Similar to the restaurant sector, after factoring in the short-term hits to revenue, we see value in many of those companies that we think have long-term, sustainable competitive advantages. For example, narrow-moat Hanesbrands (HBI) is rated 5 stars, and with a current price/fair value ratio of 0.37, we think it is one of the most undervalued stocks across our coverage universe.
Industrial production declined 5.4% in March compared with February and registered a 5.5% drop compared with March 2019. This is the sharpest monthly slowdown the economy has experienced during the post-WWII era. Similar to the retail sales report, with most shutdown orders lasting through at least the end of this month, the April industrial production will also register a severe decline. The slowdown was widespread across all market and industry subgroups. Only sectors such as food and beverage, which should have held relatively steady, declined by less than 1%, whereas cyclical sectors were down high-single-digit to low-double-digit percentages, with motor vehicles registering the worst decline at 28%. Within the industrials sector, while we have recently reduced our fair value estimates on 3M (MMM) and Caterpillar (CAT) to account for the current economic environment, we still see long-term value in these wide-moat companies. In our view, both have the sustainable competitive advantages to successfully weather the economic storm and are trading at 4-star levels.
As dire as these declines are in the near term, we expect that the economy will recover in the second half of the year and help to offset the current economic contraction. For 2020, we project U.S. gross domestic product will only decline by 2.9%. In our base-case scenario, we expect that current efforts will begin to reduce the number of COVID-19 cases by the end of May and we will be able to begin lifting restrictions in June and July. In addition, we anticipate that waves of drug treatments for COVID-19, such as Gilead's (GILD) remdesivir and targeted antibodies, will help to mitigate the impact of the disease and that a vaccine will be developed and available in 2021. Gilead's stock is one of the few to buck the downward trend this year and has risen approximately 15%. Following this rally, the stock moved to a 3-star rating from 4 stars. Our U.S. economic forecast is based on the impact from the fiscal stimulus in conjunction with the impact of mitigation strategies at the industry level. For a detailed description of our economic view, please see "Coronavirus Update: Long-Term Economic Impact Forecast to Be Less Than 2008 Recession."
Disclosure: This article has been written on behalf of Morningstar, Inc., and is not the view of DBRS Morningstar.
David Sekera does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.