US equities’ steady upward march even as economic and company data worsens by the day has left many investment pros scratching their heads. Yes, economies and markets will eventually recover. But how do we divine the path back to something like normal?
More to the point, what is the market thinking? Is there some irrational flush of exuberance on hopes that the coronavirus is fading? Is it our old friends FOMO and TINA – aka Fear of Missing Out or There is No Alternative? Or is there simply blind faith in central banks?
There are tools to back out what the market might be pricing in now, as the S&P 500 pushes above 2900 – roughly where it was last October just before mounting the final rally that ended in February. Here we employ a dividend discount model and scenario analysis and find that there is rhyme and reason behind where equities are trading – and a clear indication of how equities may react if or when markets revise some key expectations.
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US equities’ steady upward march even as economic and company data worsens by the day has left many investment pros scratching their heads. Yes, economies and markets will eventually recover. But how do we divine the path back to something like normal?
More to the point, what is the market thinking? Is there some irrational flush of exuberance on hopes that the coronavirus is fading? Is it our old friends FOMO and TINA – aka Fear of Missing Out or There is No Alternative? Or is there simply blind faith in central banks?
There are tools to back out what the market might be pricing in now, as the S&P 500 pushes above 2900 – roughly where it was last October just before mounting the final rally that ended in February. Here we employ a dividend discount model and scenario analysis and find that there is rhyme and reason behind where equities are trading – and a clear indication of how equities may react if or when markets revise some key expectations.
Our Basic Approach…
Recall that in theory the value of a stock or index such as the S&P 500 is the present value of dividends that an investor expects to receive over time. The textbook formula is:
Where D0 is current dividend, r is the required rate of return (or cost of capital), g is the dividend growth rate over time and p is the stock or index price.
Today, of course, the earnings and dividend stream is anything but constant, especially over the next couple of years. So rather than use the formula above, we come up with two earnings and dividend scenarios over the next few years, then assume dividends grow at a constant rate for the next 40 years and discount back to the present to come up with fair SPX levels.
…And Now Some Assumptions
In a modelling exercise like this, assumptions are everything.
Long-run earnings outlook – We have little choice but look to the past for clues about how earnings may evolve going forward. As Charts 1a and 1b show, S&P 500 earnings growth has fluctuated widely during the ups and downs of the economic cycles. But the long average has been fairly steady at near 6% over the past 25 years. Further, the dividend payout ratio has been in the 35-40% range. Once the economy stabilizes, we assume earnings and dividends grow at a constant 6% annual rate.
Recovery earnings outlook – Projecting earnings over the next few years is more problematic. We start with the observation that there were major earnings downturns during the recessions of the early 1990s and the Great Financial Crisis. Earnings fell 40% y-o-y, then bounced 40-60% as recovery took place, then settled down.
At the time of writing, consensus forward EPS is $133, down from $173 in February. The lowest estimate we have seen is $110 by Goldman Sachs or a 35% decline.
For this exercise we start with the Goldman estimate. We then project two scenarios: a “normal” cycle where earnings recover roughly in line with the major cycles of the early 1990s and 2009-2011; and a “slow” cycle where earnings remain depressed for longer and recover more slowly (Chart 2). The base case projects the February EPS estimate assuming the coronavirus crisis didn’t happen. Essentially the normal scenario is a V-shaped recovery.
Discount Rate – A final critical assumption is the discount rate. We take mid-February SPX levels – 3,300 and projected EPS of $173, and a 40% payout ratio and project out 40 years. The internal rate of return is 6.1%. This is essentially the return or risk premium investors receive for this projected stream of dividends. We assume the market continues to require this risk premium.
And We Conclude That…
The results are surprisingly robust. Our base case scenario is the first line of Table 1 – this assumes a 6% long-term dividend growth rate and a 6% required return. The fair value for the SPX in the normal recovery scenario is 2,823 – near the present level. In the slow recovery scenario, fair value is 2,567.
The market appears to be pricing something more like a V-shaped recovery as opposed to a Nike Swoosh profile.
Let’s consider some sensitivity analysis to get an idea of downside risks and upside potential.
What if the earnings and dividend growth rate is only 5% instead of 6%? This might be the case if the labour force shrinks after the crisis or if consumers became more cautious and reluctant to consume as they did before the crisis. Either could reduce GDP and earnings growth. Now, fair value for the SPX falls by about 19% (second line of Table 2).
Another possibility is that investors become willing to accept a lower return on equities. The yield curve has fallen roughly 100bp since mid-February and real rates are 50bp lower. In addition, Congress and the Fed have demonstrated that they will go to great lengths to support financial markets. What if investors become willing to price equities’ dividend stream at 5% instead of 6%? If earnings and dividends grow at a long-term rate of 6% after the initial recovery, then equities are clearly cheap in either recovery scenario (Table 1, line three). And even in the slower 5% growth scenario with a normal initial recovery, fair value is 2,876, near today’s market.
Where Does That Leave Us?
Quite simply, investors today seem strongly oriented toward a traditional V-shaped recovery as we move beyond the coronavirus crisis. If the recovery process proves to be slower than expected, or if the economy and earnings are unable to return to their previous long-term trends, equities face considerable downside risk. On the other hand, if rates and inflation remain low and confidence in government support grows, there is also considerable potential upside.
Inevitably, an analysis of this nature raises more questions than it answers. There are always other assumptions you could make, and these results shed little on which scenario might be more likely.
For what it’s worth, I’m more concerned about the downside risks. But one must also acknowledge that both society and markets are in the midst of a major regime shift. I’ll leave it to readers to assign probabilities to these prospective scenarios and invest accordingly.
Over a 30-year career as a sell side analyst, John covered the structured finance and credit markets before serving as a corporate market strategist. In recent years, he has moved into a global strategist role.
(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)