Uncertainty and Panic

It feels awful when account values are down, but it is much worse to feel awful because you are sick. First priority is for everyone to protect themselves and their families through frequent hand-washing, social distancing, and self-quarantine if you feel symptoms.

In my last report on February 25, I predicted that if the market expected the economy to go into recession, that the market could drop another 15% from that point, which was a price level of 2659 for the S&P 500.

The S&P 500 value has now overshot that prediction by 5%. The price closed yesterday at 2480.64. This implies that the market is definitely predicting a recession and it may be worse than expected.

When emotions run high, it helps to fall back on the numbers.

Stock prices and Corporate earnings

It isn’t unusual for the market to overshoot on the downside when fear is running high. Being level-headed when others are in panic will lead to better outcomes.

We know that the correlation between stock prices and earnings are high over time. The problem is that we don’t know how far earnings will fall. While we are seeing a sharp drop in demand for many parts of the economy, other areas are holding up.

Earnings forecasts for the full year have only dropped slightly because some of the decline that we expect to occur through June, is getting picked up in the second half of the year or pushed into next year.

A lot can happen between now and, as I mentioned, the market is pricing in a recession. Given the uncertainty we can determine a range of outcomes based on a high, medium, low scenario of earnings.

Step One:  Earnings Forecasts Pushed Out

In the chart above, you can see that the earnings expected for this quarter has dropped from the fourth quarter of 2019. There is still an expectation that sales will occur, but it has been pushed to the end of 2020 and into 2021.

Step Two: Low, Medium, High Earnings

For the low earnings, let’s use the actual earnings that companies earned in 2018, which is when the market was last panicked about recession. The S&P 500 index earnings was $161.93 per share in 2018.

Let’s use the current earnings estimate for the year for the mid-point. Currently it is expected to be $173.30 per share for 2020.

On the high end, let’s assume that companies only grow half as much as what is currently expected for next year, 2021. Wall Street analyst estimates are calling for almost 12% earnings growth next year. Let’s cut that growth rate in half, to 6%. Earnings would be $183.60 per share.

Step 3: Apply a range of earnings multiples (P/E)

Currently the market is trading at 14.3 x forward earnings. At the end of January, before the virus was known to be a threat, the S&P 500 was trading at 20 x forward earnings.

Using a range of multiples, 12x, 14x, 16x, and 18x, and applying that to the range of low, medium and high earnings, the following is a range of returns based on the closing price of the S&P 500 today, 2480.64:

Usually during a stock market panic, the price declines faster than the earnings adjustments, so by definition, the multiple drops. As earnings are adjusted lower, the multiple actually increases again.

It is the uncertainty that scares investors most. Once the severity of the earnings decline is understood, the rebound begins. This has happened during every panic including the recessions of 2008, 2002, 1990 and 1981. Multiples climb as earnings become more certain -- this happens even when the earnings are lower than before the panic.

We obviously don’t know what the severity of the pullback will be yet and the next month will be critical.  It will depend on the government response to stop the spread of the virus and on how they will support the economy once the threat has passed.

Until we hit the peak rate of infection, expect the volatility to continue, and take care of your health.

At Archer Bay Capital, we help navigate our clients through market volatility so we can make better financial decisions together. Contact us to discuss stocks, earnings and our forecast in greater detail, or to schedule a consultation today.