WASHINGTON—There’s a common fear that Wall Street, buoyed by bullish sentiment, has gotten far ahead of the economic recovery and corporate earnings. However, despite continued volatility and uncertainty, analysts don’t expect a sharp market correction and say there’s still room for some upside for U.S. stocks ahead.
Much better than expected economic data combined with positive news on drug treatments and potential vaccines for COVID-19 have bolstered investor confidence in recent months. But a spike in coronavirus cases as reopenings advance and the potential for a Democratic win in November pose downside risks to the stock market, according to analysts.
Following steep losses in March, Dow Jones and the S&P 500 soared nearly 40 percent from their lows on March 23. The Nasdaq Composite also rose 52 percent, climbing above 10,000 for the first time in its history.
Morgan Stanley analysts don’t believe the stocks are expensive or way ahead of the fundamentals.
“Our contention has been that the V-shaped recovery in markets is simply foreshadowing the V-shaped recovery we expect in the economy, and more importantly, in earnings,” Michael Wilson, chief U.S. equity strategist at Morgan Stanley, wrote in a report dated June 29.
The forward 12-month price-earnings ratio, a common gauge used for judging equity market valuations, was trading at the high end of a preferred 19–21 valuation range, according to Wilson.
However, he noted that “markets trade at peak multiples when earnings forecasts are at the trough of the cycle, like now.”
He believes earning forecasts of S&P 500 companies have bottomed already and are “likely to exhibit a very steep increase over the next six months as is typical coming out of a recession.”
When earnings rebound, these valuations will no longer look expensive, according to Morgan Stanley, which forecasts further upside for the S&P 500.
For the first quarter of 2020, the average earnings decline for the S&P 500 was 15 percent year-on-year, according to FactSet, a financial data provider.
Wall Street analysts now project that the earnings decline in the second quarter will be nearly 44 percent, marking the largest decline in earnings since the last quarter of 2008 (-69.1 percent).
Profits are expected to decline further in the second half of the year, according to analysts. But they expect earnings to rebound by 28 percent next year, which will recover all the losses of 2020.
“We don’t think that the market is so richly overpriced and that there needs to be a sharp correction anytime soon,” Joel Prakken, chief U.S. economist at IHS Markit, told The Epoch Times.
Low interest rates and the possibility of some medical advances are making investors feel confident, but disappointing earnings and cuts to dividends work in the opposite direction, he said.
“So we see the market sort of treading water,” he said.
According to Prakken, the pandemic has caused “a dichotomy within the market” as firms that are aligned with the technology sector have performed well. This has helped the Nasdaq break records several times in the past month.
Technology stocks have been top picks for investors, as they’ve benefited from stay-at-home orders caused by the pandemic. Netflix and Zoom Video, for example, surged 68 percent and 143 percent, respectively, from their March lows.
“Technology is our most favored sector, but we also favor consumer discretionary, communication services, health care, and financials,” Scott Wren, senior global market strategist at Wells Fargo Investment Institute, told The Epoch Times.
These sectors will continue to benefit from the economic environment until the end of 2021, according to Wren.
“It all comes down to consumer spending for the stock market,” he said.
“If we are all still sitting at home in September, October and afraid to go out because of virus concerns, the stock market is likely to be lower. We need confident consumers with jobs, out spending money and driving the economy forward.”
According to many forecasters, consumer spending will be the key driver for the economy in the next 18 months as businesses are less inclined to spend amid uncertainty.
Markets Fear Biden’s Win
Most Wall Street analysts believe the stock market’s rally could be threatened if presumptive Democratic nominee Joe Biden wins the presidential election in November.
According to Morgan Stanley, the recovery in the stock market is being challenged by “the potential for a Democratic sweep in November, which may lead to a rollback in the 2017 corporate tax cuts and potentially other policies deemed to be unfavorable for stocks.”
Goldman Sachs said Democrats would be negative for corporate profits. In a June report, the Wall Street firm predicted that a rollback of tax cuts could lower its S&P 500 earnings estimate for 2021 by 12 percent. Biden earlier said he would reverse parts of the 2017 tax reform if he gets elected.
CNBC reported in June that the options market began to indicate a negative outcome for the S&P 500 as some investors were betting on a market sell-off following the election with the fear of Democrats winning the presidency and both houses of Congress.
The RealClear Politics average of polls shows Biden leading Trump by more than 8 points.
According to Prakken, it’s too early to say whether the Biden presidency will be negative for the markets. He said Biden could be a tailwind to stocks particularly if his election “brings with it political stability and renewed confidence.”