The Stock Market Has Become One Big Value Trap

Watching equities rally strongly for a second consecutive day, pushing the S&P 500 Index at one point to its highest level since March 11, it was hard not to be reminded of one of the most famous lines in movie history, or at least among fans of the Star Wars franchise. In 1983’s “Return of the Jedi,” the rebel alliance mobilizes its forces to destroy the Death Star during the Battle of Endor. But the rebels get ambushed, prompting Admiral Gial Ackbar to shout “It’s a trap!” And, just like that, equities gave up all their gains on Tuesday to post a slight decline.

At its highest point on Tuesday, the S&P 500 was up 23% to 2,757 compared with last month’s closing low of 2,237 on March 23. The two main reasons given to explain the rebound are optimism that officials may be getting ahead of the curve in the battle to contain the coronavirus pandemic and what looks to be deeply discounted valuations on stocks following the fastest drop into a bear market in history. It remains to be seen whether Covid-19 is coming under control. When it comes to valuations, though, the optimists may well have fallen into a trap. A value trap is a well-known phenomenon in markets. It happens when a security or asset appears inexpensive relative to any number of metrics. The trap springs when the price of the security or asset continues to languish or drop even further. Indeed, stocks did look cheap, with the S&P 500 going from trading at close to 20 times this year’s estimated earnings down to 14 on March 13, which was the lowest since early 2013, according to data compiled by Bloomberg. But that was before analysts starting cutting their 2020 profit estimates, dropping them to $152 a share from $175 at the end of January. As a result, stocks no longer look so cheap, with the S&P 500’s price-to-forecasted earnings multiple jumping up to a not-very-inexpensive 18 times. The problem is that many analysts have held off slashing their profit estimates, deciding to wait until they hear from company executives when the first-quarter earnings reporting season begins in a few weeks. In other words, get ready for earnings estimates to fall even further, which should weigh on sentiment and valuations.