What Gives?

Following the stock market’s historically strong performance in April, at the end of the month, the S&P 500 Index had gained nearly 30% from its year to date low achieved on March 23 when it was down by more than 30% for the year and nearly 34% from its all-time high close from February 19. With the market less than 15% away from its all-time high and down just 10% for the year as of the end of April, many investors have pointed out and questions the seeming disconnect between the market’s sharp reversal and recovery thus far in the face of a very bleak economic environment. Many investors have asked: what gives? Surely the news is bad, why isn’t the stock market more worried? Is the market too optimistic and getting ahead of itself?

One logical reason as to why the market is only down by 15% or so is that stock prices depend very heavily on their long-term earnings. Stocks are ownership interests in real businesses that represent a claim on all of a company’s residual cash flows (i.e., earnings that can be distributed in the form of dividends and/or buybacks) in perpetuity. Accordingly, the stock market, in aggregate, derives its value from the cumulate earnings power of all of the companies in the market into the indefinite future. There is real value in this, the preponderance of which comes from these companies’ long-term earnings capacity. Ultimately, one- or two-years’ worth of earnings simply do not account for much of an individual company’s nor the broader market’s total value.

To illustrate this point, consider a hypothetical investment that offered to pay you $100 this year, 4% more the next year, 4% more the year after, and so on, indefinitely into the future. In addition, suppose you judged there to be some risk in the investment such that you felt you needed a 9% return to feel comfortable making this investment. How much would should you be willing to pay for this hypothetical investment in order to earn your targeted 9% annualized return? Fortunately, this is a tractable problem that can be solved quite easily. The mathematical fair value of a perpetual $100 cash flow that grows 4% per year, discounted at 9% is $2,000.

How much less should you be willing to pay if there is now cash flow to be received in year one, but rather, the first cash flow is to be received in year two? In this scenario, the intrinsic value of the investment is roughly 8% lower, $1,835. And, if you chopped off one more cash flow such that the first flow isn’t received until year three, the fair value falls further to $1,683, approximately 16% lower than the initial value.

This hypothetical example demonstrates that for very long-dated assets (i.e., those that provide a stream of cash flows long into the future), near term cash flows, while certainly valuable, only account for a relatively small slice of the asset’s intrinsic, fair value.

Now, as a highly simplistic example, imagine our hypothetical investment from above to be an investment in the aggregate stock market. In other words, think of it as buying an ownership stake in all of the companies in the market. After all, most observers would agree that it’s reasonable to expect the market’s aggregate earnings to grow by roughly 4% per year in the future, on average, and most would also consider a 9% return to be reasonable long-term return expectation as well. Thus, I consider it reasonable to think of an investment in the aggregate stock market as very similar to the hypothetical one presented above.

Viewed in this light, we can see just how much of the aggregate market’s value comes from its long-term earnings, not this year’s or next year’s earnings. Our example above demonstrates that in a wildly unrealistic and draconian hypothetical scenario in which the COVID-19 crisis entirely wipes out the market’s earnings in 2020 and in 2021, it would permanently impair the aggregate value of the—and justify a market decline—of just 16%. Such a scenario would be truly unprecedented and far worse than anything experienced historically—during the last market crisis that began in 2007, aggregate S&P 500 Index earnings declined by less than 50% from 2006’s high to 2008’s low.

Back in the real world, the market consensus appears to anticipate that 2020 will undoubtably be a bad one from an economic and earnings perspective but that 2021 will witness a recovery that continues into 2022 and beyond. Bottoms-up analysts’ expectations for S&P 500 companies anticipate aggregate earnings to decline by 22% in 2020 vs. 2019 before recovering entirely in 2021. This strongly supports the idea that the stock market’s sharp correction over the past few weeks is a very rational and appropriate reaction to a potentially very short but painful recession.

Sources:

S&P 500 Index daily values from Yahoo Finance.

S&P 500 Index earnings from S&P Dow Jones Indices (accessed on 5/6/2020).

Important Disclosures

Kathmere Capital Management (Kathmere) is an investment adviser registered under the Investment Advisers Act of 1940. Registration as an investment adviser does not imply any level of skill or training. The information presented in the material is general in nature and is not designed to address your investment objectives, financial situation or particular needs. Prior to making any investment decision, you should assess, or seek advice from a professional regarding whether any particular transaction is relevant or appropriate to your individual circumstances. This material is not intended to replace the advice of a qualified tax advisor, attorney, or accountant. Consultation with the appropriate professional should be done before any financial commitments regarding the issues related to the situation are made.

The opinions expressed herein are those of Kathmere and may not actually come to pass. This information is current as of the date of this material and is subject to change at any time, based on market and other conditions. Although taken from reliable sources, Kathmere cannot guarantee the accuracy of the information received from third parties.

The hypothetical examples do not represent historical or current investments and are intended for illustrative purposes only.

An index is a portfolio of specific securities, the performance of which is often used as a benchmark in judging the relative performance to certain asset classes. Index performance used throughout is intended to illustrate historical market trends and performance. Indexes are managed and do not incur investment management fees. An investor is unable to invest in an index. Their performance does not reflect the expenses associated with the management of an actual portfolio. No strategy assures success or protects against loss. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk. All investing involves risk including loss of principal. Investing in stock includes numerous specific risks including: the fluctuation of dividend, loss of principal, and potential liquidity of the investment in a falling market. Past performance is no guarantee of future results.