Patrik Schowitz

Earnings season will tell if stock market optimism is justified

Most market watchers predict a drop and bounce-back in profits sharp enough to be called V-shaped. If they are right, the reporting of second-quarter company earnings now under way should reflect a turning point in global profits downturn

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A man stands next to a bank’s electronic board showing the Hang Seng Index in Hong Kong on July 21. Markets’ forward-looking nature means they have been able to move well ahead of the real economy to price in an expected recovery in corporate profits. But are they right? Photo: AP

Patrik Schowitz

Published: 5:00pm, 24 Jul 2020Updated: 10:19pm, 24 Jul 2020

The sharp contrast between stock markets marching higher in the face of increasingly bleak headlines and economic carnage from the virus has been bewildering.

To wit, global equity markets fell by 34 per cent from February to March, but have already recovered the vast majority of that drop by now. That turmoil now feels like aeons ago. Stocks are now less than 5 per cent below their all-time highs set in February.

Meanwhile, in the real world, while economies are getting back on their feet, they have a long way ahead to fully recover.

A key reason for this divergence is markets’ forward-looking nature: it means they have been able to move well ahead of the real economy to price in an expected recovery in corporate profits – the fundamental driver for stocks. That’s why prices anticipating earnings growth in the future look expensive today. At some point, however, earnings will need to catch up and justify investors’ rosy optimism about future growth.

The earnings season under way now will be a first test. It matters because corporate earnings reports for the second quarter will probably be the turning point in the global profit downturn caused by Covid-19. It will reflect the darkest time for companies, when economies came to a virtual halt to contain the virus. Investors will be combing through company reports in search of information on just how deep the hole in the second quarter was and how fast the recovery is likely to be from here.

What should help is that the make-up of stock markets around the world is quite different from that of economies. Details vary across regions, but the basic trend is consistent: manufacturing is over-represented in equity markets, while services are under-represented.