On days like today the emotional mind wants to take us to the worst case scenario, with markets down 60, 70, 80%. But while it is difficult (near impossible) to do on a -13% day, we need to be consciously rational.
What we are facing here is unprecedented. We are in the midst of a generational event, a near complete shut-down of our society for an undetermined amount of time. We have a VIX over 80 at an all-time-high and we’ve seen 2 of the top 3 percentage declines in history in the last week.
We can spend all day talking about the possibilities. The paths that this storm could ultimately take are numerous, like the cone of uncertainty that the weather channel projects out for hurricanes. Maybe it will skip off the eastern seaboard and out to sea. Maybe it will slam in to NYC. But there are probabilities to those outcomes. So to make any sort of real forecast, we have to make assumptions that try to take in to account the high probability outcomes.
Assuming that:
1. We are late but not too late in our social distancing and quarantine measures, and we do manage to flatten the curve of these infections in a manner not quite as good as South Korea, but not quite as bad as Italy. We reach peak infections 2 weeks from today at the beginning of April, and by mid-April new cases are rapidly decreasing. By early May we are cautiously getting back to our businesses and lives, even if the effects will linger for many months more.
2. US hospitals experience significant stress, and thousands – perhaps even 10 thousand or more – of our fellow Americans die from this disease in the coming weeks. The headlines get worse before they get better. But ultimately, the healthcare system does not experience a total collapse, and after a few weeks the tide begins to recede.
3. The federal government passes an absolutely massive fiscal stimulus package, maybe even more than one, on the order of $1T plus dollars. We backstop whole industries, put money in to consumers’ wallets via a payroll tax cut or direct payments, we expand unemployment benefits, give small businesses interest free loans, and more.
4. The virus does in fact wane during the hotter weather, and the epidemic subsides as we get in to late Spring.
4. Effective treatments and vaccine progress is made over the next six months and by the start of the next ‘flu’ season, we are close to mass roll out of vaccinations.
So, where would that leave us by summer?
We have 0% rates, low gas prices, extreme fiscal and monetary stimulus, a market at a 30+% discount, some industries at 50-70% discounts, and a consumer that has been cooped up inside and been through a harrowing ordeal. We see a drastic re-acceleration of economic activity in the late second, third and fourth quarters.
2019 S&P 500 earnings were about $165 – with year-end analyst estimates for 2020 of $174 – a ~5% increase.
Assuming that the 5% increase is wiped off and an additional 15% decline in earnings for the year, for a total forward earnings decline of 20%, puts us at about $139 range for 2020 earnings.
At the end of the year we were trading at about 18x forward earnings, which expanded in January. Don’t forget, we were up 10% already on the year before this all started.
Assuming a forward earnings number of $139, you get the levels below with multiples of 14x-18x. The 20 year average forward p/e is about 15.5x.
A 15.5x forward multiple on earnings of $139 gets you to 2154. Another 9% down from Monday’s close. This is a pretty pessimistic, but not catastrophic scenario. $139 earnings is a serious decline. The 20 year average p/e of 15.5x is skewed because of the GFC. For much of the last decade it has been above 16x.
I believe that this is a high probability outcome. Hope is never a good strategy – but let’s hope.
