S&P 500 potential EPS growth paths from COVID19 growth shock

Potential S&P 500 EPS paths

In the base-case scenario the median of the predicted distributions of EPS is more or less flat in 2019 before growing slightly in 2020 leading to a three-year period (2018-2021) of stagnating EPS growth for the S&P 500. In this scenario risk aversion would likely increase holding back any earnings multiple expansion. In the worst-case scenario the median path takes down EPS by 10.5% which significantly more than the 6.2% EPS decline during the China/EM slowdown in 2015-2016 but nothing like the 49% decline during the financial crisis.

The plot also shows the 25% and 75% percentile paths for the two scenarios. The first observation is that that potential range of outcomes is large in both cases which reflects that our two variables cannot fully explain quarterly variance in earnings. This leads us to the next phase which is where art takes over from the model. Where do we think the EPS path ends up in the predicted distributions?

Our naïve forecast is that the “true” GDP growth path will be something in the middle of our two scenarios based on our view that the virus will almost impossible to contain and that human behaviour in a global pandemic will create a significant demand shock to the economy. Most of the unknowns related to COVID-19 have larger downside than upside risks and thus our view is that the EPS path could end up around the 25% percentile. Taking the average of the two scenarios put the EPS decline over the next two years at minus 28%. This very negative outlook reflect severe nonlinear effects on the downside from human behaviour (demand shock) and as a result credit events (bankruptcies, investment shock), and lastly prolonged supply disruption in a global supply chain that has not spread its production capacity risk properly but concentrated it in Asia.

Impact on S&P 500

The average of the two 25% percentile EPS paths translate into S&P 500 EPS at $108.76 by Q4 2021. Since 1954 the average P/E ratio has been 16.6, but if we assume that the P/E ratio will only contract from current levels to around 18x as low yields and low inflation have a positive impact on the earnings multiple then the impact on the S&P 500 will be significant.

This earnings multiple combined with EPS tracking the average of the two 25% percentile paths leads to S&P 500 at around 2000 in Q4 2021 (that’s 35% below today’s level). If we use the average of the two median paths then EPS will be $145.93 in Q4 2021 and with an earnings multiple of 18x then S&P 500 is priced at around 2600 (that’s 16% below today’s level).

You may think it sounds a bit too crazy but remember that the dynamite here is a valuation multiple contraction reflecting an impact on risk aversion by investors. If you believe P/E ratio will stay unchanged then of course the impact on S&P 500 will be significantly less from current levels. But remember we don’t know the future. This is an exercise in risk management and providing a broader spectrum of outcomes than what you are probably thinking.

Our next update will go through a multi-stage growth model for pricing S&P 500 to see what the current decline in S&P 500 tells us of the market pricing of the expected earnings decline.