Cumberland Advisors Market Commentary – S&P 500 After COVID-19

Author: Leo Chen, Ph.D., Post Date: June 1, 2020
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The S&P 500 Index is widely used as the benchmark for over $9.9 trillion in investments. After losing 35.4% in just a month, the index has rebounded 36.5% from its March 23rd bottom. These extraordinary numbers during extraordinary times are unlikely to continue after COVID-19’s impacts on the market subside. So what can we expect from the S&P 500 after the pandemic? We will discuss the question from market-construction and earnings perspectives.

The S&P 500 Index selects 500 leading companies that are domiciled in the US, by market capitalization. The 505 stocks – yes, there are 505 stocks in the index at this moment due to different class shares – currently total about $25 trillion in market cap. Along with market cap, financial viability is another important criterion for selection to the index: The sum of the four most recent consecutive quarters of generally accepted accounting principles (GAAP) earnings, as well as the most recent quarterly earnings, are required to be positive. Some large-cap stocks have experienced sharp drops, unprecedented in magnitude, during the COVID-19 sell-off. For example, Macy’s lost 81.3% from its all-time high in February, and Boeing lost 77.2% from its all-time high in March. Unlike Boeing, Macy’s was removed from the S&P 500 at the first quarterly rebalancing because of its small market cap. The market cap threshold for the S&P 500 is approximately $2 billion now. If uncertainty about the second wave of COVID-19 keeps market volatility around the 25–40 VIX level, then it is possible that the S&P 500 will reshuffle a few more stocks this year. Moreover, the earnings requirement could add to the purge in the index.

Chart 1. S&P 500 Total Weight

Because the S&P 500 is a cap-weighted index, the asymmetrical impacts of COVID-19 on the 11 sectors will likely diminish and inadvertently narrow representation in the S&P 500. For instance, the three largest sectors, Information Technology, Health Care, and Communication Services, account for 25.7%, 15.4%, and 10.8% of the index respectively; while the three smallest sectors, Energy, Real Estate, and Materials, together account for only 8.4%. As Chart 1 above shows, the top five stocks (Microsoft, Apple, Amazon, Facebook, and Alphabet) account for approximately 19.3% of the index weight – above the 18% that these five reached during the tech bubble – while the top 40 stocks account for about 50%. The average year-to-date return of the largest five stocks is 15.36%, meaning that these five stocks alone have contributed roughly 3.14% growth to the S&P 500 Index in 2020. If crowded trades continue, the index may experience even more concentrated growth from the largest companies. COVID-19 could narrow market leadership to an extent we have never seen before.

Chart 2. Largest Five Stocks YTD Performance

Earnings uncertainty will be a big question mark. According to FactSet, the current yearly earnings estimate for the S&P 500 is $128.49, down from $177.81 on December 31st, 2019. In addition, one third of S&P companies have pulled their guidance. If we use the current earnings estimate as our baseline, today’s S&P 500 level reflects a 23X P/E multiple. As Table 1 below shows, if the multiple remains at 23, earnings per share need to be almost $148 for the S&P 500 to recover to its previous all-time-high of 3386. However, as evidenced by Table 2, P/E can rise significantly above the historical average during a bear market recovery, especially when interest rates are suppressed. Since the Fed is set to keep rates at zero for the foreseeable future, it would not be impossible for the S&P 500 to hit a new all-time-high in 2020, as analyzed in Table 1.

Table 1. P/E Sensitivity Analysis

Table 2. P/E History

In a word, COVID-19 has distorted the equity market. The S&P 500 may become even more mega-cap-fixated than before. Earnings uncertainty may surprise investors to the upside with P/E multiple expansion, thanks to the Fed’s zero-interest-rate policy (ZIRP). But as a word of caution, P/E investing may be quite unreliable, since we do not have any clear image of earnings going forward. But P/E will certainly be a helpful indicator once we get to the second-quarter earnings season.

(Data from Bloomberg as of May 26th, 2020)

Leo Chen, Ph.D.
Portfolio Manager & Quantitative Strategist
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