- The disconnect between rising stock prices and falling earnings is making it difficult to assess the market's valuation.
- There may be reason for optimism if the virus curve is flattening, especially in light of the massive policy intervention from the Fed.
- The discounted cash flow (DCF) model is a useful tool to frame the question of what the right value is for the stock market, and what the market is currently discounting.
- Using the DCF, 4 potential recovery scenarios can be mapped out for US stocks: a checkmark-shaped recovery, V-shaped, U-shaped, and L-shaped. Currently the market seems to be pricing in a U or a V.
With the stock market lurching around in ways that few of us have ever seen before, it's getting more and more difficult to keep up with the price action.
Even compared to the extreme days of the global financial crisis, the current news flow is difficult to comprehend. Joblessness is in the millions, Q2 GDP could decline 20%, and city streets have been empty for weeks.
Stock prices are moving opposite fundamentals
About the expert
Jurrien Timmer is the director of global macro in Fidelity's Global Asset Allocation Division, specializing in global macro strategy and active asset allocation. He joined Fidelity in 1995 as a technical research analyst.
The market seems to have now entered into a state of suspended animation, with price moving in the opposite direction from the fundamentals. While the economic data and earnings estimates are in free-fall, the S&P 500 Index (SPX) has now rallied 28% from the March 23 lows and has retraced 50% of the decline. As of Friday, the S&P 500 Index is a mere 18% from the high. It's barely even a bear market anymore!
The rally is making it difficult to assess the market's valuation. With some strategists now expecting earnings to fall 20% in 2020, the forward price to earnings (P/E) ratio has risen even as the economic news has gotten bleaker. At an SPX of 2,789 and 2020 EPS of $125, the 2020 P/E is 22x, higher than where it was at the top.
A flatter curve and policy intervention
Does this mean that investors have gone berserk? Not necessarily. It all makes sense in its own way, given the many moving parts. The market is always discounting the future, and when the future is this uncertain the price discovery process becomes chaotic to say the least.
The narrative behind this better price action seems to be an improving risk-reward dynamic.
For one, the COVID-19 curve may begin to flatten this week in the US, as it already has in parts of Europe and Asia. Second, the Federal Reserve is taking measures that few of us could have ever imagined. Friday's announcement that the Fed will buy high-yield bonds was yet another such moment.
The policy intervention is helping investors look across the abyss rather than into it, and that's what is behind the improving tone in the market. Don't fight the Fed, as the saying goes, especially when it is coming out with guns blazing.
The DCF (discounted cash flow model) to the rescue
Making sense of the ongoing price discovery is difficult when we look only at expected earnings and P/E ratios. Fortunately we have the discounted cash flow model (DCF)* to help make sense of things.
Because we need to price in the recovery as well as the shock, the longer-term framework (5 years) of the DCF offers a robust way to look at the entire arc of the COVID crisis. With the DCF, we can peer across the abyss.
But how do we price in a recovery during such uncertain times? What follows are 4 scenarios for how this arc might play out. That's the first part. The second part is to compare those scenarios to where the market is currently trading. From there we can draw conclusions as to what is priced in, and what is not.
I am a big fan of Aswath Damodaran's DCF model, which uses a combination of dividends and buybacks to calculate the “cash payout” to shareholders. In my view this is a more robust approach than considering just earnings per share (EPS) or free cash flow (FCF) or dividends. So that's what I am using below.
In recent years, the SPX has paid out around 88% of earnings as “cash” to shareholders (buybacks are not literally cash, but they are considered a proxy for cash). For instance, in 2019 the S&P 500 earned $157 in operating EPS, paid out $58/share in dividends and $81/share in buybacks. The 2 add up to $140, which equals 88% of EPS.
For the following examples I am using a risk-free rate (10-year Treasury yield) of 0.6% and an equity risk premium (ERP) of 5.5%.
1. Best case (checkmark)
Let's call it the checkmark recovery, and I consider this to be the best-case scenario by far. This scenario uses the current consensus earnings estimates from Bloomberg (BBG) for 2020, 2021, and 2022, and assumes no change in the payout ratio.
Based on last week's consensus estimates, 2020 EPS will be $147, down from the 2019 EPS of $157 (or $163 using the blended "current" EPS from BBG). From there EPS will grow 18% in 2021 and another 13% in 2022.
The BBG estimates basically assume a temporary shock followed by a very sharp recovery, back to where earnings would have been if it wasn't for COVID-19. In other words, it's a super-charged V.
In my view, this seems way too optimistic, and I doubt it will happen (but it would be nice if it did). For one, again in my view, any earnings estimates right now are highly suspect, given that companies are not providing guidance.
Nevertheless, these are the consensus estimates as of right now, so it's worth taking into consideration.
Based on the above, the fair value for the S&P 500 is 3,398, which is about where it was at the February highs (3,394). It's as if nothing happened, and it suggests that as of last week's close the market is still underpriced by 21% (600 points).
It would be amazing if this is what happens, but I am not holding my breath.
2. Good case (V)
For this scenario I am assuming a 20% decline in EPS in 2020 (to $126), followed by a V-shaped 25% recovery in 2021 (to $157), followed by on-trend growth of 7% after that (the long-term compound annual growth rate—CAGR—for EPS). Again, I am assuming no change to the payout ratio of 88%.
This produces a fair value of 2,916, which is 4% above last Friday's levels.
3. Middle case (U)
Next, I am assuming a 20% EPS hit for 2020 followed by a more moderate recovery of 10% in 2021 (implying a more gradual return to normalcy), and then trend-growth of 7%. Again, I am assuming no change to the payout ratio.
That produces an intrinsic value of 2,579, which is 8% below last week's close. This fair value level was where the market was 2 weeks ago, before it gained 12%.
Based on the above 2 scenarios, one could conclude that the market has gone from pricing in the U-scenario 2 weeks ago to pricing in the V-scenario last week. Saying this in another way, through the DCF lens we can explain last week's 12% gain as the market transitioning from pricing in a U-scenario to a V-scenario.
OK, so those were all reasonably optimistic scenarios, from glass half-full, to full-full. I'm happy to take a U, V or checkmark after what the world is going through now. For the above 3 scenarios the S&P 500 has returned to at least fair value, with possibly more upside ahead.
4. Worst case (L)
Now let's take a look at a more pessimistic scenario. Let's assume that not only will the recovery be slow (more like an L or swoosh), but that there will also be a permanent reduction in share buybacks. That would be a double-whammy of slower earnings growth and lower shareholder payouts.
Let's use the same 20% hit to 2020 EPS, followed by on-trend growth of 7% after that. I am also assuming that share buybacks decline from the $81/share to $50/share and stay there. This would cause the payout ratio to fall from 88% to 64%.
In this scenario I am assuming that the financial engineering era will be a victim of the COVID crisis. The narrative about that might be that only the strong cash flow generators will be able to buy back shares, but that the weaker players (who are either getting financial assistance or need the credit markets) will not.
This L-scenario produces a fair value for the S&P 500 of 1,871. This is 45% below the all-time high and 33% from last week's close.
What is priced in?
My rationale for running the above scenarios through the DCF model is twofold. First, since price and earnings are now moving in opposite directions, we need a more robust valuation framework that considers the entire arc of the COVID crisis (decline and recovery). Second, with these different scenarios quantified as a fair value for the S&P 500, we can see what the market is pricing in at any given time.
We can come up with myriad assumptions and scenarios, from the timing of the bottom to the slope of the recovery, to what ERP (equity risk premium) to use, but this is a start. My point here is to build a framework that helps us make sense of the market's rapid price discovery process. If you have a particular set of assumptions in mind, please let me know and I can run the math.
From worst case to something else? Time will tell
My conclusion from the above analysis is that at the March 23 lows (−35% from peak) the market was on its way to pricing in the worst-case L-scenario (−45%), but that the robust policy response enabled the market to move away from this possible left tail outcome.
At the same time, the market is also not (yet) embracing the right tail best-case scenario (checkmark). Rather, the S&P 500 seems to be somewhere in the middle, between a U-scenario (−8% from current) and a V-scenario (+4% from current). Two weeks ago it was at the U, and last week it was closer to the V.
If it does turn out that the arc ends up being somewhere between a U and a V scenario, then the good news is that the left tail can be ruled out, and therefore the recent gains are not in jeopardy (beyond the usual back and forth). But it also suggests that there is little if any upside from current levels, given that the market has already priced in most of a V-scenario. And it seems implausible to think that the market can just keep rallying to new highs in a right tail scenario, as if nothing happened. There is just too much damage for that, in my view.
So maybe the 50% retracement of the past few weeks is as far as it goes for now. Maybe this retracement marks the start of a prolonged trading range that will be defined by the U-scenario on the downside (say 2,500 on the SPX) and the V-scenario to the upside (say 2,900). It seems like a plausible outcome while we wait for the next chapter to unfold.