What is the stock market downside from here?

Uncertainty and Market Volatility Continues

In our last blog in mid-June, we predicted a choppy market over the summer and strengthening into the fall. The biggest uncertainty at that time was whether there would be additional trade war threats.

That threat came to pass when plans for new tariffs were announced at the end of July.

                  S&P 500 Year-to-date Return      18.3%
Return from a year ago, August 31, 2018      2.9%
         Return from the July 26, 2019 peak      -3.1%
           Return from the Dec 24, 2018 low      22.6%

There are more signs that a recession may be coming from an inverted yield curve in the bond market to a decline in corporate capital spending and global manufacturing output.

Potential offsets could come from stimulus spending by China, Germany, and Japan, as well as another cut in interest rates.

As usual, there is a lot of uncertainty, so let’s review what we know.

Corporate Earnings Growth Low — But Better Than Expected

The stock market rises when the rate of growth is increasing, even if it is from low levels. At the beginning of 2019, analysts had expected earnings growth to be negative in the first quarter and it didn’t happen. Then earnings were forecasted to decline in the second quarter, but that didn’t happen either.

The current forecast is for it to be negative now, but we won’t know if forecasts are correct until corporate results are reported in October.

Then the debate will be whether the fourth quarter will recover or decline again.

Maybe the forecasts are wrong and corporate earnings will fall significantly. We can see from the strong stock market returns this year what happens when earnings growth increases.

But, what will be the downside if it declines?

Corporate Earnings and Price/Earnings Ratio

The most common measure for valuing a company's stock is the price-to-earnings ratio. Take the price of a stock, or, in this case, the price of the S&P 500 Index, and divide it by the earnings.

As of last Friday, August 30th, the price of the S&P 500 was 2,986. The aggregated earnings expected for next year, 2020, is $183.35. This number represents the combined earnings of all of the companies within the S&P 500 and scaled by the size of each of the companies.

This ratio has many uses in the industry. One of them is to test the potential upside/downside of either a stock or an index, like the S&P 500.

How Bad Can It Get…Based on What We Know Now?

When the market gets spooked and investors run for the exits, two things happen. First, prices drop, which lowers the price to earnings ratio. Second, there is a lag before earnings forecasts start to decline too.

Using various scenarios, we can derive an estimated range of a hypothetical market decline.

Hypothetical Decline: Between -14% and -22%

The math is optional, so skip to the next section if you don’t want to do it.

For the math geeks, when the price drops (the numerator) and the earnings stay the same (the denominator), the ratio can decline rapidly.

Last December when the market was expecting a recession, the P/E ratio for the S&P 500 dropped from 17 to 14 (based on 2019 earnings). It took a few weeks for the earnings forecasts to decline.

As earnings dropped, the revised denominator pushed the ratio back up. When investors believed that earnings forecasts had reached a bottom, the price started to rise again, which further lifted the ratio.

To reach the low of last December, earnings forecasts for 2020 need to drop 10% AND the ratio needs to fall to 14. Usually there is a lag effect to the denominator change, so applying a low ratio and a big decline in earnings does not normally happen simultaneously.

A market decline of -14% represents the P/E dropping to 14.

It is a coincidence that both numbers are 14. It’s just decreasing the ratio from 16.3 to 14, nothing more.

A market decline of -22% is applying a P/E of 14 AND an earnings decline of 10%.

What should investors do next?

With the S&P 500 up 18% year-to-date, if the hypothetical declines described above happened in the next four months, returns for the year would range from positive 4% to negative 4%, thus resulting in not a great year — but not a disaster, either.

As we mentioned in June, it’s better to stay the course and stop watching the daily ups and downs in the market. The rational approach may not help the TV ratings for financial news shows, but it works for your portfolio.

At Archer Bay Capital, we believe focusing on the big picture is the best way to reach your long term investment goals. Contact us to learn more about forecasting returns for your portfolio, or to schedule a consultation today.