Let’s look at the S&P 500 index and what some implications of the changing fundamentals due to the current situation have on its fair value. This analysis is based on a Discounted Cash Flow model of the S&P 500 index. I am taking the current index operating levels as reported by Standard and Poor’s and applying forward looking estimates to get a sense of what the fair value of the index is. This valuation is based on forward looking estimates; therefore, the result is only as good as the estimated inputs. A further warning, this is not a recommendation to buy, sell, sell-short, enter into a straddle or strangle or any other creative strategy that you may be able to think up with your broker. Now that I have finished my disclaimer section, let us look at some of these numbers.
My analysis is based off the most recent numbers reported by the S&P, this analysis will be updated as future estimates/actual financials are reported. At the time of this writing the index currently sits around a level of $2,924.4. Future estimates are based on analyst opinions of a 24% drop in operating income in 2020 for the entire index. My analysis diverges from the estimates for 2021 however, I have placed a 10% growth rate on operating earnings in 2021 from the 2020 level. Over the last 4 years the historical average growth in operating earnings on the S&P 500 has been 10.5%. From the estimated 10% growth in 2021 I am estimating another year of historical growth in earnings and then reducing the growth rate linearly to the 10yr T-bond rate which currently is at 0.64%
Now moving on from operating earnings we get to cash returns on the index. Cash is returned to investors in two ways, the first being direct payments to investors via dividends. The second mechanism of returning cash to equity investors is buying back share. Looking at 2020 I dropped the total payout ratio (inclusive of both dividends and buybacks) by 38% from a payout ratio of 93.07% to 57.7% as companies move into survival mode and need to preserve cash. After 2020 I moved the payout ratio back to a level of 90% and increase it throughout the next 4 years to 97.8% in the terminal year. Based on these estimates, I am calculating a fair value of the index at $2,747.45, a 6% discount to the current level.
Playing around with the expected recovery in earnings in 2021 if we factor in a complete recovery in earnings in 2021 (a 25% increase over 2020 earnings) the model derives an intrinsic value of $2,924.66, or a 0.01% difference to the current level. It looks like the market is pricing a complete recovery in 2021.
Now to the interesting part, does the current market level make any sense? Honestly, I have no clue. This is an unprecedented situation where the future has never been so murky. There are a couple camps of thought however that can help lead your analysis of the situation. First, we need to think of the current economic contraction as either a supply issue, a demand issue, or a combination of the two.
A supply issue would imply that there is demand for goods and services, but the current lockdown environment is creating a barrier for that demand to translate into purchases of goods and services. With this argument a complete recovery of earnings makes sense as once the economy is fully open GDP should recover to previous levels.
A demand issue is a little more interesting. A demand issue would imply that consumers will not be purchasing at the same levels when the economy gradually reopens as fear sets in and they want to hold onto excess cash. This would point a much longer recovery in economic activity as it would take consumers much longer to be comfortable returning outside and living in the same pre-COVID manner.
A likely outcome is that we will be facing both supply and demand issues. As the outlook for re-opening the economy becomes clearer, capacity limits will play a major role. Just from common sense, capacity limits will imply lower revenues from businesses as their turnover will take hits while their fixed costs remain high. Companies with high overhead like retailers will be particularly hurt. In addition to capacity limits, a certain portion of the population will remain afraid of returning to normal activities. This would imply a contraction from both supply and demand ends.
History can be a good indicator of where we will end up in the future in this situation. Looking at the 2008 Financial Crisis for example there was a 2.5% drop in real GDP (inflation adjusted) between 2008 and 2009. Looking at the unemployment rate after the Financial Crisis it took 8 years after for the unemployment rate to recover to pre-2008 levels. Real GDP however recovered to pre-Financial Crisis levels by 2010.
Looking at the movement in the S&P 500 during the Financial Crisis, it dropped from a high of around 1,400 in May of 2008 to a low of around 670 in March of 2009, a drop of more than 50%. The index did not recover to near pre-Financial Crisis levels until after 2011.
GDP in 2020 is expected to contract by 5.6% (source: https://www.cbo.gov/publication/56335). The unemployment rate currently stands at 14.7% and by some calculations the figure rests at a near Great Depression level of 23.6% (the peak of the Great Depression was 25% unemployment rate). Hiring should pick up as businesses re-open, however looking at capacity limits and a reduced consumer demand it seems hard to believe that unemployment will reach the 3.7% at the beginning of 2019.
The reaction to the COVID-19 lockdowns by the stock market was swift and severe. The index dropped from a high of around 3,400 in February to a low of around 2240 in March a drop of 34% in the span of one month. The recovery has been just as swift as the index has jumped from the low of 2240 to the current levels of 2920, an increase of approximately 30%. This puts the current level around 14% below the highs set this year. If the economy is expected to fully recover in 2021 as I laid out in the above DCF analysis, the current recovery in the market makes sense at a fundamentals level. However, if the economy is not operating at full capacity for the remainder of this year and into 2021 the recent upswing could be out of line with reality.
Will the economy bounce back in 2021? The short answer is nobody knows. If significant progress is made towards a vaccine which can be distributed to the population there could be a recovery in 2021 which would imply that the index is close at a fair value. However, another important thing to consider is how the virus will impact operating costs which will impact overall earnings. Companies already are spending more to protect their employees from infection and while the pandemic rages on it could be expected that the trend will continue. I believe the more likely outcome than a complete recovery to 2019 levels of profitability in 2021 will be a slower longer increase in index operating earnings followed by a recovery in the index payout ratio. A key question to keep asking during times of extreme uncertainty is, does this make sense? The current recovery in the market to me does not make much sense considering the future struggles that we will face.
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