The models are broken
The market is trying to get back to the pre-Covid and pre-war times, but that model is broken. A new dawn is here and the financial world needs to adapt.
Chief Investment Officer
Head of Equity Strategy
Summary: The COVID-19 virus may have little impact on long-term earnings growth even if the short impact could prove quite large. In order to evaluate the outlook for the S&P 500 investors must focus on the potential hit to the short-term earnings outlook and animal spirits, or risk aversion. We provide a crude model for predicting future EPS for the S&P 500 based on two GDP growth shock scenarios. It shows that the S&P 500 could be in for a tough two years in a worst-case scenario.
In yesterday’s equity update we went through the different factors that have an impact on equities and how they stack up after last week’s carnage. Our main message is that indicators suggest more pain ahead for equities, but overall any prediction comes with high degree of uncertainty. It all comes down to whether the COVID-19 virus can be contained or not. Equities reflect discounting of future cash flows and thus COVID-19 impact on those cash flows is necessary to quantify in order to make judgements on S&P 500 being mispriced or not. The long-term growth rate for profits are not impacted by a virus so the key is the short-term impact over the next two years. In this update we try to make a crude model for EPS path off two scenario of growth shocks from the COVID-19 outbreak.
The model assumes that quarterly changes in S&P 500 12-month trailing log EPS can be modelled using US GDP growth y/y and quarterly changes in GDP growth. The is very crude and other variables obviously play a role, but we will get back to that later. Our model is a quantile regression model in order to capture quantile effects and not just the mean response. This provides us with a framework for assessing the prediction interval in an extreme event. We use data from Q1 1954 to fit the quantile regression.
GDP growth scenarios
Our two growth scenarios are called base- and worst-case and try to capture a “mild” shock taking US GDP growth briefly to zero percent followed up by a quick rebound to trend growth with a slight overshooting due to pent-up demand in the economy (think post 2008 financial crisis). The worst-case scenario assumes a significant GDP growth shock taking the growth rate from 2.3% in Q4 2018 to -2% by Q4 2019 superseded by a slower recovery not taking GDP growth back to trend until sometime in early 2022.
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.
Chief Investment Officer
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