The coronavirus pandemic has left millions unemployed and caused the largest quarterly decline in GDP since the Great Depression. Not surprisingly, this has led to deep uncertainty about the ultimate length and depth of the recession and the shape of the eventual recovery.
Economic uncertainty always leads to stock market volatility. But there is also a common pattern across most recessions. First, the stock market drops severely as the bad news spreads, accelerated by panic selling by some investors and automatic triggers in some algorithmic trading. Usually, the overall effect is an overreaction that savvy investors exploit by buying shares, which in turn leads to a full or partial rebound long before the economy has fully recovered. In the current situation, both the decline and the rebound took place very quickly. The S&P 500 index dropped by more than 30% near the end of March. As of mid-June, it had jumped back to within about 5% of its value at the beginning of the year.
What explains the disconnect between the pain of unemployment and a major recession on the one hand and the relative resilience of the stock market on the other? The market response can largely be explained by two factors. First, the market values the long-term profits and cash flows of companies, not just this year’s and maybe next year’s. Do the math and you will understand why even such extreme times as we are experiencing today do not necessarily have a major effect on the value of companies in aggregate. No one knows the extent and length of this economic downturn, but let’s assume that corporate profits will be 50% lower than they otherwise would have been for the next two years and then return to levels that are permanently 5% lower than otherwise. Discounting the impact of these lower profits and cash flows suggests a decline in the present value of the stock market of less than 10%—not far off from where we are (as of early July).
Even such extreme times as we are experiencing today do not necessarily have a major effect on the value of companies in aggregate
The second reason is that the industry composition of the S&P 500 has changed substantially over the past 25 years. It is now heavily weighted to companies in technology, media, telecommunications, pharmaceuticals, and medical devices. These fast-growth industries have doubled their share of the index to about 40% while slow-growth industries (such as industrial and consumer products) have declined from about 35% to 20%. The industries on the rise are more affected by the introduction of new products and services than the health of the broader economy (and in some cases have even benefited from the current economic situation). In fact, the shares of companies in these sectors are generally higher now than at the beginning of the year. Conversely, oil and gas and travel-related companies are down by 20% or more, but because of the change in the S&P 500 weightings, these declines don’t have nearly the impact on the market index that they would have had 25 years ago.
There are a few other factors at play in the stock market reaction. Some large employment sectors, such as department stores, were already suffering before the pandemic hit. Their market capitalizations were low at the start of the crisis so further declines didn’t have much effect on the index. Additionally, many high-employment sectors—including restaurants, dry cleaners, and local services—are dominated by privately owned companies whose pain doesn’t affect the S&P 500.
Sometimes investors and analysts seem to overlook these fundamentals in valuing companies, focusing too much on earnings multiples such as price-earnings or enterprise value-to-earnings ratios. When you believe that company valuation is driven by multiples, it is tempting to think that a 50% earnings reduction will lead to an equivalent decline in value. That would hold if the earnings multiple were to stay constant. But when earnings suddenly decline, the earnings multiple will have to go up if there is an expectation that the company will recover partially or completely.
This may be counterintuitive: in times of crises, most people would not expect multiples to increase. Yet that is what the fundamentals would predict. And if we look at the US stock market during the current crisis, this’s what has happened: the short-term earnings outlook came down, but the price-earnings multiple went up. At least as of June, the decline in value for the US stock market has been not nearly as strong as the decline in the short-term earnings outlook.
Tim Koller is co author of Valuation, the seventh edition of which was published this past spring. He is also co leader of McKinsey and Co.’s Strategy and Corporate Finance practice.