Musings on Markets Mon, 09 Mar 2020 12:22:00 GMT language
I wrote a post on how the Corona Virus was playing out in markets on February 26, two days into the market going into convulsions, and while I tried to make an assessment of the value effect, I also said that this analysis was a work in progress, that I would revisit as we learned more about the virus and its economic consequences. Eleven days later, we still don't have clarity on the health or economic effects of the virus, but we do have substantially more data on what the market reaction has been. In this post, I will begin by doing a quick update on the viral spread across the world, but spend more time on the market damage, looking at where it has been greatest, seeking clues for the future.
|NY Times, as of March 6, 2020|
Earnings Growth: In my 2/26/20 valuation of the S&P 500 index, I argued that the corona virus is now almost certain to cause earnings effects for companies, and estimated the drop to be 5% (a significant revision down from the 5.52% growth that had been predicted in the index. In the last few days, analysts have started adjusting earnings expectations down for companies, and this snapshot from Zacks today captures some of the adjustment:Note that the expected earnings on the index for 2021 has dropped from 172 for next year, two weeks ago, to 163 this week, matching the earnings generated in 2019. That is still better than the 5% drop that I was projecting, but my guess is that I am still undershooting the actual earnings decline and I have increased the expected earnings drop in 2020 to 10%. To complete the assessment of growth, I also need to estimate how much of the earnings drop in 2020 will be recouped in future years. In my valuation on February 26, I had estimated that half of the earnings drop in 2020 would be recouped but that the rest would be lost for the long term. I will continue to hold on to that assumption In addition, since my long term growth rate converges on the US T.Bond rate, the precipitous drop in that rate has lowered my growth rate in perpetuity to 0.74% (to match the T. Bond rate).
- Cash flow Payout: The second component of value is the cash that companies can return, in dividends and buybacks. I assumed that companies, driven by uncertainty, would scale the percent of the earnings that they return to stockholders from the 92.33% that they were returning prior to the crisis to 85%, more in line with the ten-year average. In the days since, there have been no announcements of dividend cuts or scaling back of already announced buybacks, but I would not be surprised to see that change in the next few weeks.
- Discount Rate Dynamics: The discount rate dynamics are the trickiest. On the one hand, the lower T.Bond rate will create a lower base from which to build up, but the increase in volatility (actual and expected, as captured in the rise in the VIX over the last three weeks) has pushed equity risk premiums up. I will scale up my ERP to 5.69% to match my implied premium at the start of March 2020.
|Download valuation spreadsheet|