Apparently Goldman strategists expect profits for companies in the S&P 500 will decline 33% this year, and rebound 55% next year. It implies a V-shaped recovery. Let’s forget that 2021 is a long way off and that their guess is as good as anyone’s at this stage. It’s what happens in the meantime that is more interesting even if they prove to be more or less correct.
I wanted to visualize the idea of recovery consistent with my own long experiences so decided to use one of my tried and true translations (well not ‘mine’ really, but courtesy of Ford Equity Research).
Ford’s price to value ratio (PVA) is computed by dividing the price of a company’s stock by the value derived from a proprietary intrinsic value model. A PVA greater than 1.00 indicates that a company is overpriced while a PVA less than 1.00 implies that a stock is trading below the level justified by its earnings, quality rating, dividends, projected growth rate, and prevailing interest rates. While looking at the PVA for an individual company can give a good indication of its value, the average PVA for the market as a whole can provide insight into current valuation levels.
As you can see from the graph below, their PVA provides a nice picture of the market as it’s valuation rises and falls in relation to its intrinsic value. Of course, the intrinsic value changes as growth expectations and interest rates change. But it helps illustrate what is meant when market pundits talk about a V or W or U-shaped recovery looks like.
Although the market seems to be hovering (albeit with substantial volatility) at current levels, the consensus seems to be expecting it to test the lows again. I read a comment that suggested that sometimes the consensus is right. Balderdash – it’s never right. In fact when I did a forecast for the Okanagan CFA Forecast Dinner a long time ago, all I had to do was survey the crowd and predict the opposite – my opposite forecast proved to be right-on naturally.
What is NOT embedded in expectations (or current valuations) is that the market resumes its downward thrust. Say Goldman’s strategists are right and the S&P 500 earnings come in at about $110 for 2020. On Friday April 3rd the index closed at 2,488.65 so the forward P/E multiple is 22.6X. I would argue (again based solely on decades of experience) that this is a ridiculous multiple when growth is negative, despite a near zero interest rate. I would also argue that to value companies based on 2021 earnings today is absurd, since we’ve no real idea when we’ll hit rock bottom; if a recovery will occur, when it will occur and how strong or weak any recovery might be.
Looking at the graph again, you can probably see why I sold all my funds in the 3rd Quarter of 2018 and have been waiting since. In order to commit to the market again I need to see the optimism go away and be replaced by investor lethargy.
There’s no simple letter that truly represents what I suspect is coming – at least not yet. A lightning bolt is more like it.
The rationale that a quick recovery is probable is based on flawed thinking. Consider this quote from an interview with TD’s CEO:
Looking a few months down the road, TD’s boss said he thinks individuals and businesses should be able to bounce back relatively quickly from this crisis, as it stems from a health care problem, rather than the deep-seated economic issues responsible for most recessions. Mr. Masrani said internal models show the North American economy growing by the third or fourth quarter this year and back to pre-crisis levels early in 2021. But he cautioned: The model is only as good as the data, and “every day it changes, based on new data.”
It’s the exact opposite. In other market corrections despite economic issues business carried on as usual. This time, all business just stopped voluntarily creating a deep-seated economic mess the likes of which we haven’t suffered before. It’s hard to imagine bankrupted companies simply finding enough capital to restart overnight if at all. It’s even harder to imagine we all decide overnight it’s now okay to start crowding into theaters, restaurants and shopping malls because the virus has ‘slowed’ down or President Trump tells us to.