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A trader reacts during the opening bell at the New York Stock Exchange (NYSE) on February 28, 2020 at Wall Street in New York City.
Photo by Johannes Eisele | AFP | Getty Images
We are all exhausted and depressed, having experienced this week one of the worst stock market declines in modern history.
I was there for the first one, on Oct. 28, 1987, when I stood with my colleagues around our communal Quotran screen while the market took a 20% jack-knife.
Let’s try to evaluate where the stock market might bottom. This involves creating some framework to assess the implicit assumptions in the market, the business sustainability, cash flow and balance sheets of the companies in which we invest.
At the current price of 2,300, around 32% below the Feb. 19 peak, the S&P trades at about 14 times earnings for 2019. If we assume that 2020 is a washout, and next year recovers to the 2018-19 level again of $165 per share, the market is still at 14 times forward earnings, which is generally not a rich multiple when considering 10-year Treasury rates are less than 1%.
One might ask, “Is this multiple too high and is that earnings estimate too optimistic?”
The market traded at 14.5 times forward earnings during the last correction at the end of 2018 but has bottomed at much lower multiples in history, including touching down 11 times forward earnings on March 9, 2009, the bottom during the financial crisis.
We might conclude that we’re in the range, not outside the perimeter, but not at the low end. There are still risks: In the last two weeks before the lowest close of that bear market, in 2009, the S&P plunged 20%, which represented a drop from 14 times to 11 times forward earnings. But, it rebounded quickly.
How about the earnings for the composite of $165 per share next year? Since the key to predicting the rebound after a recession, is forecasting how long the recession lasts, we need to think through key variables.
Estimating earnings with economy at a halt
The duration of the coronavirus pandemic will determine the length of the recession. It won’t become clear if social distancing works for a few weeks. Even with the precautions being taken by the public, the rate of daily growth in new cases is 35% to 50%, either end of which results in a range of 2.6 million to 26 million total cases nationwide in only three weeks, thanks to the powerful effect of compounding. This is why we are in for a very tough situation in the next few months. Any outcome of this magnitude will grind the domestic economy to a halt.
However, new cases in China and South Korea have dropped dramatically. June 30 is still over a quarter away, with a third more days than the entire time since China officially recognized the virus’ existence. Friends who live in Shanghai report that factories and commerce in China will be fully operational by mid-April, although the countries to whom they export goods will be hampered for many months.
If we extrapolate to the U.S. from China, where the negatives of dense pollution and heavy smoking that exacerbated the virus uptake were balanced by highly restrictive isolation that reduced the incidence, this suggests that the spread could fall significantly in less than two months, or by mid-May. If commerce and demand resume in the second half, China will be ready to ship products and corporate earnings will begin to rebound in 2021.
Comparing to past recessions
How does this compare to other recessions, such as 2008? The financial crisis was precipitated by reckless behavior of a small number of financial institutions employing millions of people. This recession will be triggered by the forced shutdown of millions of innocent small businesses employing much smaller work forces.
It was much easier to get bankers Jamie Dimon, Ken Lewis, and John Thain in a room with then-Treasury Secretary Henry Paulson and then-New York Federal Reserve President Timothy Geithner to negotiate one massive bailout for nine giant banks than to distribute funds so that every restaurant, bar, hair salon, and retailer (those still hanging on for dear life) receives some relief for their business and their staff.
The scenario that I feel most optimistic about is where we see a meaningful reduction in the virus growth rate over the next month, we relax some of the work and gathering restrictions and gradually bring back commerce and education. A huge bailout is an essential element for multiple constituents.
At the risk of being accused of naivete, I realize cases are still in the logarithmic growth phase in the U.S. and other countries, but we are also watching China’s progress, the sudden leap into action by the federal government, and the rise in available test kits. Without places to gather like restaurants, bars, schools and workplaces, we are all forced to physically distance, regardless of our inclination. So, for the time being, I will, cautiously, stick with my earnings estimate of $160 to $165 for the S&P 500 next year and a bottom of 35% to 40% from the February peak.
That doesn’t mean the market won’t have 5% to 10% gyrations over the next couple of months both up and down, whenever it becomes hysterical about a rise in COVID-19 cases, unemployment claims, or an earnings’ warning, but it feels as if there should be ample bargains to lure investors back at that point.
Karen Firestone is chairman, CEO, and co-founder of Aureus Asset Management, an investment firm dedicated to providing contemporary asset management to families, individuals and institutions.
