The stock markets have already endured a lot of pain over the past two months. Since we only saw the most recent highs back in mid-February, the fact that the S&P/ASX 200 Index (ASX: XJO) has experienced nearly a 27% fall since means we have seen one of the most rapid deteriorations into bear market territory in history.
But since mid-March, the ASX 200 has actually been remarkably stable and has fluctuated around the 5,000 point level ever since – even slightly above over the past week.
But here's why I think a further plunge is a distinct possibility, regardless of what happens next with the coronavirus.
It's the earnings numbers that ASX companies will start wheeling out before too long.
Why are earnings important in this bear market?
Earnings are important because the earnings-per-share metric is one of the essential ingredients that the market uses to work out what a company should be priced at.
See, a company's share price can be expressed using a metric known as the price-to-earnings ratio (or P/E ratio). It is derived from dividing a company's share price by how much the company generates in earnings for its owners per share.
Let's take CSL Limited (ASX: CSL) – the ASX's largest company today.
Right now, the CSL share price is sitting at $313.59 (at the time of writing), with a P/E ratio of 42.97 and an earnings-per-share metric of $7.28.
Right now, the market is telling us that it is willing to price CSL at 42.97 times what the company earns for its owners per share.
But this earnings figure is a historical statistic – a statistic that has yet to be updated for the current period. If CSL (hypothetically) reports to the market that its earnings have dropped to $6 a share for FY20, the market will have to decide whether to price CSL at a higher P/E ratio in order to keep the same share price, or otherwise lower its share price so that its new earnings number matches a P/E of 42.97.
What about other ASX 200 shares?
Now CSL is a beloved market darling and a healthcare company – so it's likely that the market will be forgiving if CSL's earnings take a dip.
But what of the other 199 companies in the ASX 200?
I think it's highly possible the market won't be nearly as forgiving. As companies report historically low earnings over the coming months, we could see share prices adjust quickly to the reality of lower earnings-per-share across the board. And that could mean a further drop in the share market as a whole.
I'm not trying to predict gloom and doom here, I just think ASX investors should be ready for anything. The recent rises in the ASX 200 might have some investors thinking we are out of the woods – but I'm not convinced we are just yet. Stay vigilant, Fools!
