Framing the Downside

Stocks are now officially in bear market territory, which means prices are down over 20% from the all-time highs just three weeks ago. In fact, at the time of this writing the S&P 500 is down nearly 24%. The fast-and-furious descent can be attributed to a pair of black swans that so rudely arrived just as investors were anticipating an improvement in the outlook for corporate earnings following a very disappointing 2019. Wikipedia describes a black swan event as “an event that comes as a surprise, has a major effect, and is often inappropriately rationalized after the fact with the benefit of hindsight.” That definition pretty clearly describes both the coronavirus and the oil-price war between the Saudis and Russians. Each was unexpected and has the potential to meaningfully impair the economy over the near term, which means that each also has the potential to meaningfully affect corporate earnings. The predictability of these events? That’s beyond the scope of this Market Commentary. We’ll let you decide whether or not warning signs could have led to action to prevent or reduce the impact of these crises.

First, it’s important to point out that earnings estimates had been falling long before the coronavirus arrived in China in December, 2019. We wrote about this trend several times over the past year. Though many market participants attributed these downward revisions to the impact of the trade war with China, we have consistently opined that the estimates were too lofty even without the negative influence from the trade war. The chart below shows that estimates for 2020 and 2021 continue to fall, but it is hard to determine how many analysts have yet to incorporate the negative impact of the coronavirus and oil-price war. Our sense is that the estimates for 2020, and perhaps 2021 as well, will continue to come down in the weeks and months ahead. How much is anyone’s guess at this point.

The next chart shows that using the current consensus estimate for S&P 500 earnings over the next twelve months, the price-to-earnings ratio (aka, P/E multiple) has come down quite significantly from over 19x in February to about 14.7x today. There are a couple things to emphasize, though. First, it is now widely believed that the denominator in the ratio, which is the consensus earnings estimate of about $173, is highly likely to keep falling. This means that today’s P/E ratio of 14.7x is likely understated. Second, if earnings estimates don’t continue to fall over the next several weeks, the current P/E ratio of 14.7x is now below the average of 15.1x since 2002.

It the next chart, we try to quantify the downside for stocks using two variables: the target P/E multiple and the year-over-year earnings growth from 2019 to 2020. As we mentioned above, the current P/E multiple on the S&P 500 is about 15x if we use the current level for the index of 2,590 and the consensus estimate for 2020 of $172.82. That estimate for 2020 would represent growth of about 6.5% over the $162.21 in earnings for 2019. If we use the current multiple of 15x and the current expected growth in earnings of 6.5%, we arrive at the yellow box in the table below. However, if we make the assumption that earnings growth in 2020 will come in closer to 0% rather than 6.5%, and we maintain the same target P/E multiple of about 15x, the market would be expected to fall another 6% from current levels. If we assume a more negative scenario that earnings fall 4% in 2020 and the P/E multiple drops to 14x (significantly below the historical average), then we might expect another 16% decline in the index from today’s level of 2,590.

The reality is that nobody currently knows where earnings will come in for 2020. It is also true that nobody knows what the correct multiple on those earnings should be. One optimistic thought is that the effects of the coronavirus, and hopefully the oil-price war as well, are widely expected to be transitory. Therefore, even if these black swans do result in a big decline in earnings for 2020, we should expect a nice snapback in 2021. If that is indeed the case, the P/E multiple on depressed 2020 earnings might be expected to rise well above historical averages. Alternatively, it’s possible that these black-swan events could lead to the next recession. Most economists believe the length and severity of a possible recession would be fairly minimal. This contention is largely based on the solid financial foundation of the US consumer, the strength of the US banking system, and relatively low level of inventories and other excess in key sectors of the economy.
We continue to advise clients to avoid making emotional decisions! Drown out the noise and keep your eye on the long-term prize. Also, please follow the advice of the CDC in implementing measures to prevent contraction of the coronavirus. We look forward to the day when this virus will be but a memory and investors are free to focus on long-term fundamentals.