Making Sense Out of the Market’s Nonsense

I have eclectic musical tastes. When I’m not snapping my fingers to Frank Sinatra, I’m grooving to The Jefferson Airplane. Last night I watched one of the finest rock concert films ever made: Stop Making Sense (1984), featuring The Talking Heads.

It occurred to me that this stock market stopped making sense, long ago. First, we witnessed the fastest bear market in history, through February and March. Then, from their late March coronavirus-induced lows, stocks have soared to dizzying heights. Severe recession, terrible corporate earnings, massive unemployment, a spiking COVID-19 death toll…nothing seems able to deter the stock market’s ascent.

What gives? As I’ve written in previous articles, the stock market is not the economy. The market is forward looking and it’s already looking past our current woes to focus on the expected return to growth in 2021. But we have to get through the rest of 2020 first, without experiencing an economic meltdown in the interim. I’m not so sure that we can.

But for now, the optimists are in the driver’s seat. The three main U.S. stock market indices closed firmly higher Wednesday, for their fourth consecutive day of gains. The Dow Jones Industrial Average posted its first close above 27,000 since June 9, a psychologically significant threshold. The Dow rose 0.62%, the S&P 500 climbed 0.57%, and the tech-heavy NASDAQ Composite edged up 0.24%.

In pre-market futures trading Thursday morning, stocks were set to open higher. Investors are optimistic over a possible COVID-19 vaccine, as well as tentative progress on a new stimulus bill from Congress.

Lawmakers in Washington are haggling over a second stimulus bill and they only have a few days to pass something before major programs such as enhanced unemployment benefits expire on July 31. Negotiations are scheduled to continue this week.

Tensions have flared up again between the U.S. and China, but investors are shrugging it off. The U.S. this week ordered the closure of a Chinese consulate by Friday, in retaliation for China’s recently exposed hacking efforts to obtain industrial secrets.

Investors would rather focus on second-quarter corporate earnings. However, earnings clarity for Q2 is elusive. Many companies have done away with earnings guidance altogether for the rest of this year because of pandemic uncertainties.

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The second-quarter operating results of blue-chip bellwethers will provide an indication of how corporate America is coping with the coronavirus pandemic.

For the second quarter, the S&P 500 is reporting a year-over-year decline in earnings of -44.0% and a year-over-year decline in revenues of -10.5%, according to FactSet. The significant decrease in earnings begs the question: how are net profit margins holding up?

Not so well. The blended net profit margin for the S&P 500 for the second quarter is 7.1%, which is below the five-year average of 10.6%. “Blended” combines actual results for companies that have reported and estimated results for companies that have yet to report. If 7.1% turns out to be the actual net profit margin for Q2, it will represent the lowest net profit margin reported by the index since Q4 2009 (6.8%). The chart tells the story:

All 11 sectors are reporting (or are projected to report) a year-over-year decline in their net profit margins in Q2, led by Financials (8.0% vs. 17.7%) and Industrials (1.3% vs. 9.0%).

Clearly, net profit margins are under pressure and that bodes badly for the rest of 2020. Higher costs and falling demand are squeezing margins. A low profit margin indicates a low margin of safety and raises the risk that a decline in revenue will wipe out profits and result in a net loss, or a negative margin.

Learning to embrace corrections…

Stocks have continued to rally, despite the economic and human damage wreaked by the coronavirus pandemic. But to justify further significant stock price appreciation in 2020, we’ll need to see a big improvement in corporate earnings. We won’t get it.

Savor your gains from the market’s rebound so far this year. In the second half of 2020, investing decisions will become even harder.

Amid these risky conditions, you should rotate toward defensive sectors, choose value over momentum, and keep plenty of cash (about 45%) on hand. When the market corrects later this year, you want to have the wherewithal to buy outstanding stocks at bargain prices.

You should welcome corrections. They’re healthy, restore balance, and make intrinsically strong stocks affordable again. That’s what history consistently teaches us. The basic rules that govern investing never change. To quote a famous song lyric by Talking Heads frontman David Byrne: Same as it ever was.

John Persinos is the editorial director of Investing Daily. You can reach him at: