Would be interested to get people’s take on this. Digging into analyst expectations for companies in the S&P 500, estimates have been cut by only 8.4% since year end, and are still 6.2% higher than LTM earnings, despite the complete shutdown of the economy. Stripping out Airlines and Energy (the two sectors where estimates have been slashed since analysts can’t ignore $25/barrel oil and a 90%+ reduction in air travel), estimates are only 5.7% lower than at year end, and 9.2% higher than LTM EPS. These estimates remain even though Goldman Sachs just estimated that GDP will fall 6.2% for the year, and operating leverage will push earnings down far more than 6.2%. Unemployment could hit 15%+, and we announced the lockdown-type environment shall remain at least the end of April, resulting in near zero revenues for a swath of businesses that employ millions, including airline, hotels, restaurants, and retail.
Admitting this is EXTREMELY basic way of looking at it, but roll with me here. At a 30,000 foot level, if you assume that revenues fall by 6% in 2020 (Goldman’s recent GDP estimate) and apply the S&P 500’s average 2019 gross margin and earnings margin, operating leverage hurts results, and EPS will fall by approximately 18% in 2020 – a far cry from the current 6% estimated earnings growth. This would imply a 1,975 level on the S&P 500 using the average multiple on the index since 2008. At one standard deviation lower than the average (13.7x), we’re at 1,720. At an all-time low multiple of 10.0x from 2008, we’re at 1,248. I am not saying I think we get there (I don’t), I am simply showing these levels to hopefully illustrate just how inflated valuations still may be.
Thoughts?
I think if EPS is temporarily depressed, people should be applying higher multiples than they'd normally apply. Forward EPS growth is higher.
More intuitively to me: if an asset's value is the earnings it will generate for a lifetime (say 30 years) and I'm going to lose 18% out of one of those 30 years, we're talking about a very small hit to value on that basis.
Lastly I get that the market got down to 10x in 2008, but that's just one time and questionable whether that could happen again with fed funds rate at 1.3% today vs what, 4.7% back then?
First off, the value of that first year is the most important, and changing that number has the biggest impact. You're also assuming that if a Company was going from EPS of 10 in 2019 to 12 in 2020 to 15 in 2021, that now you're going to go from 10 in 2019 to 5 in 2020 and then all the way back to 15 in 2021, which is an absurd assumptions for the vast majority of companies.
I specifically said I did not think we were going to get to that all time low multiple, but given where GDP expectations are, and where unemployment is going, I don't think that using the historical average multiple, or one standard deviation lower than the average multiple is out of the question. Interest rates being as low as they are won't get someone who was living paycheck to paycheck and is now unemployed off the couch and buying a new iphone/car/home anytime in the near future, and unless the fed is going to push rates negative (I guess its possible at this point), they now have used all their ammunition before the recession has even started.
A full stop of the economy is unprecedented, and is more like a depression than a recession. I think people are missing the forest through the trees, and as was said in The Big Short, "People hate to think about bad things happening so they always underestimate their likelihood."
I don't see why year 1 would have special importance. Unless of course you're using that year as a basis to model future years and thus your cut to year 1 has a domino effect. But based on your example, I was assuming we're just talking about an 18% earnings loss in year 1 which I'd expect to have an incredibly small effect on a stock price.
The relevance of rates is that investors won't be able to hide out in bonds like they did in 2008.
I don't think Fed has used nearly all its ammunition. They can buy every financial asset they want with a simple act of Congress expanding their legal authority. Even without that act, they can go pretty far just under their current legal authority.
Only thing I see limiting the Fed's ability to print is that it ultimately undermines the credibility of the currency, from either a runaway inflation perspective or a reserve currency perspective. That does concern me a bit, though I think demand for dollars overseas will give them a free pass this round and a few more times. Long run, we'll need to live a more solvent lifestyle as a nation. I'm not invested in anything that a belt-tightening consumer wouldn't be buying.
But that's my longer term view. In the immediate sense I don't think they're close to out of ammo.
Wasn't really trying to debate your application of multiples, I thought you were asking so I was just telling how I approach it. Its more intuitive to me to model the company to steady state and then apply the terminal multiple. Applying a multiple today instead, that has to account for non-steady state years, has always felt clunky to me. I know its popular though.
Here's the problem with just printing money to buy your way out of this issue...
https://www.cnbc.com/2020/03/27/op-ed-growth-of-government-corporate-de…
Neque architecto non suscipit veniam ab. Est et suscipit enim qui iste aut.
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