• Stonewood AM

Have Markets Recovered?

The big question is, have markets already recovered from the COVID-19 and the Oil Crisis?

If you look at the S&P 500 (US Equity) year-to-date you would almost think so. Markets are down about 10% from their starting point in the year although they were down around 31% at worst. All of this in the space of around 8 weeks makes for a bit of a wild ride.

The market has been down 10% at some point almost every year since about 1923 but on average has generated a positive return of somewhere between 7%-12% per annum over the long run. (I refer to US Equity only when I talk about “the market”.) A 10% drawdown is therefore not uncommon or reflective of a market crash at all.

Yet, if you look at GDP expectations across the globe, unemployment numbers and earnings expectations or the lack thereof one has to question whether a 10% drawdown in equity markets is sufficient to explain the current market conditions.

Here are a few economic data snapshots just to reiterate this point.

The US Unemployment rate has hit 14.7% as of April 2020. This is not only the highest since 2005 as the chart shows but the highest number seen since this source of data started measuring unemployment in 1948. This equates to about 23 million people unemployed in the US right now. At the beginning of 2020, that number was around 5,5 million people. It's worth noting that this data will likely get worse from here.

US GDP contracted by 4.8% in Q1 of 2020. This number is at the end of March 2020. Considering that the lockdown has only taken effect from around mid-March the impact on the second quarter is likely to be far more significant with certain economists expecting a contraction in the region of 20% in Q2 2020.

Consumer Spending in the US is down around 7.5% as of March 2020 (source, US Bureau of Economic Analysis) and being a primarily consumption-based economy you can imagine what a knock-on effect this will have on earnings of corporate America. (Again, note I am using the US as a proxy for the world in this example as per above.)

We have not mentioned the impact that the oil saga has had on the US or other oil producing economies specifically, but the US does have a substantial oil/energy sector which is compounding its current problems. This is not unique to the US but is also not shared by all markets and economies. Oil importers, for example, will be better off as a result of cheaper input prices while price remains lower and employment and earnings numbers will not have this headwind, but in a global economy if the US, EU or China sneeze global trade and growth tends to get a cold.

Q1 earnings for many US companies have now been released with around 86% of companies reporting results. Now as per the above train of thought Q1 is still not a true reflection of what things are really like at ground zero because for two of the three months of the first quarter much of the world was still at work and trading. This means Q2 numbers could be substantially worse although using company guidance alone could be misleading simply because of how unique the current economic lockdown is. Regardless of this caveat, aggregate earnings for US S&P 500 companies was down 13.6% in Q1 of 2020 which is the largest month-on-month decline since the Q3 of 2009 (Global Financial Crisis).

What is even more interesting is if we chart both earnings growth and the price of the S&P 500 together as the chart below does. You can see that EPS dropped significantly in the first quarter but the price seems to have retraced much of the initial drawdown. Q2 is expected to show earnings per share growth drop of more than 25% although where that ends up is anyone's guess with almost two months still to go in the quarter.

Source: FactSet Earnings Insight - 8 May 2020

Before I get too far down this rabbit hole, it is important to note though that if we look at history the biggest drops in prices do not equate to a one-to-one drop in earnings or vice versa. Therefore, the above chart is not necessarily out of line with what we should be expecting.

The below table shows a breakdown of the earnings in the teeth of some of the largest bear markets in history. As you can see it clearly does not show an exact connection. Earnings have dropped more and less than markets in different bear markets. The GFC, which is the most recent significant bear market, saw earnings drop far more than prices. Which does not tell us anything specifically but does prove that earnings can drop far more than prices which seems to be what we are currently seeing if we use Q1 earnings growth and Q2 earnings growth expectations as a comparative point.

It is probably worth pointing out that this picture is made more confusing by the fact that in 4 out of 7, the environment’s earnings rebounded to previous highs faster than the market did.

Source: A Wealth of Common Sense, The Relationship Between Earnings and Bear Markets

If you are a little confused at this point, I cannot blame you because there seems to be a host of contradictory conclusions in some of the charts or data provided.

The returns coming out of the bottom of most bear markets despite earnings plummeting has historically been very encouraging. This is in line with the point made above about 10-year forward returns being attractive at lower valuation starting points (when CAPE Shiller PE Rations drop below average). Again, it is worth pointing out that this is simply an indication of what has happened historically and not our conclusion. At roughly -10% YTD for US Equity it would be tough to make the case that we are in a “Bear Market” although it was down over 30% at some point, albeit so briefly if you missed two trading days you missed it.

Source: A Wealth of Common Sense, Returns from the Bottom of Bear Markets

Perhaps at this point, it is worth simply considering how most assets are valued. The answer is, for the most part, is via some form of discounted cash flow calculation. You should not pay more for an asset than you expect to receive from it in future cash flows (discounted to today's price) otherwise you will be reducing your net worth by acquiring these assets.

This is true for most assets one can think of. Equities, real estate, fixed Income, credit etc. are all valued via some form of discounted future cash flows (could be dividends, coupons, net operating income or any other). These are then discounted back at the cost of capital, considering the long-term growth expectations and some terminal value for the assets. Now I won't go much further here because the nuances here are many but I think a general idea should make sense.

Now the sensitivity of the current price to any of the variables is multi-faceted but let us assume that all else is equal for just a second. (So I think interest rates will remain at current levels and that the long term growth rate of the cashflows is also unchanged. The only thing that I want to change is the cash flows used in the next few periods.)

I have created a little DCF (Discounted Cash Flow) model to illustrate my point. It is very basic, but the concept is sound. I am using a 10-year time horizon and I just want to show the impact on price if the first few cashflows are impacted in my overly simplistic model.

If we assume that many companies have had a significant drop in earnings or no earnings whatsoever then the first entry in your discounted set of cash flows could be a very reduced number or even zero if there are no profits as a result of the reduced earnings. (I am assuming annual cashflows in the valuation model.) Now a zero or 50% reduction in the first cashflow has a major impact on a set of cash flows with a short time horizon like 5 years and a less significant impact on something being valued over say 30 years.

Please see the theoretical example below used to model three different sets of assumptions and the impact this has on a theoretical share price:

There are of course many permutations of this and I am only showing a very oversimplified example but the basic message should be coming through here.

When we tie that back to the S&P500/US Equity metaphor we have been using throughout this article you will see its relevance. A back of a matchbox calculation -- which is basically what we did using reduced earnings and earnings expectations, massive unemployed numbers and GDP numbers -- seems to show there is a little bit of a disconnect between where the S&P 500 and most global markets currently are in terms of valuations.

The spanner in the works seems to be the reaction of Central Banks and Governments across the globe in terms of the scale and speed of monetary and fiscal interventions. The impact of these interventions on current market dynamics and future expectations is very difficult to model or ascertain as this is unprecedented in almost every way.

If an airline has no earnings for 12 months and deeply reduced earnings potentially for the next few years but the cost of capital is close to zero due to reduced interest rates and policymakers that are willing to lend to that business indefinitely at almost no consequence (via debt and equity purchase, debt forgiveness or other) then what is the true value of that entity?

Well, the market seems to think on aggregate the answer to that question is around 10% less than it was willing to pay 4 months ago when global growth was positive and the world was humming along. (Caveat most airline stocks are down far more than 10% YTD, closer to about 60% YTD)

Wrapping it up...

As mentioned at the start of these two sections. These are the things we are grappling with at the moment. There have been no material conclusions reached that would impact our current portfolio construction and asset mix. As such, all portfolios as it stands remain as they are in terms of asset allocation, exposures, diversification mixes and beta optimizations.

What the above has done however is made us question whether the disconnect between prices and what seems to be the status quo is going to have a material impact on long term return expectations and trends. Many of you may have already jumped to that conclusion, which is not the intention of these discussions. It does on the face of it appear that equity markets either need to correct somewhat, and by correct we mean a price decline, or earnings and the stimulus being injected into the system need to support earnings to the extent that the current prices are justified. We are not 100% certain which of the two is most plausible, but assessing the probabilities, we are modelling the impacts these two outcomes will have on portfolio assumptions and construction.

If we get to the point that material changes are deemed justified in order to achieve the fund objectives and mandates, we will communicate with all investors. However at this point, observing the market is probably more interesting than it has been in 20 years. I think the next few months will give a very strong indication of what to expect in terms of trendline growth and return numbers for the foreseeable future.

We want to thank our investors for their continued support and confidence. We continue to focus on preserving wealth and doing so in a way that increases the probability of investment objectives being met. No matter what assumptions we build into our models, this risk mindset will always be part of our DNA and as a result, we think we will continue to manage your assets in a way that we believe consistent with our client's requirements.

We understand this is a difficult time for many of you and your families. We are here to support where we can and for us, that means preserving wealth the best ways we know-how.

Stay safe.

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