Monday March 9th, 2020 was historic on Wall Street. Curious that the downturned occurred on the 11th anniversary of the 2009 market low. The overnight futures market trading hit trading curbs, with trading halted most of the evening and into early morning on a 5% drop. Oil also dropped by 30% overnight ending the day down about 22%. When the U.S. stock markets opened in the morning, curbs were hit quickly at a 7% downside and markets were closed for 15 minutes. Credit markets are also in turmoil. Markets reopened leading investors to possibly wonder about the value of their stocks. Even with the bounce on Tuesday, since major support levels were hit, the indicators still show more downside in the near term.
Americans spend a lot of time researching the price of items they buy such as automobiles, refrigerators and wines. They tend to know the value of these items and complain bitterly if they overpay for them and tend to brag if they ‘get a bargain.’ Yet many do not know how to value their investment portfolio, and actually own stocks, bonds and other investments that may be above or below fair value at any given time. While the Coronavirus will be touted as the culprit for stocks falling; stocks were extremely overvalued before the virus hit.
It is necessary to understand how most of Wall Street values stocks. What is the worth of a stock? The answer is- it depends, just as it does for the consumer items listed above. There are growth stocks, dividend stocks, value stocks, defensive stocks and just as many types of cars, fridges and wine. What the market says they are worth could be a good answer. When one purchases a bottle of wine for example, they do not expect to pay $100 a bottle for Kim Crawford Sauvignon Blanc when it ‘trades’ for about $13 at Costco, (this is for illustrative purposes and may or may not have been purchased or used by the writers of this blog). One may pay a good deal more for a bottle of Chateau Rothschild-Lafite, one of the most expensive wines in the world with an average price per 750 ml reaching $911. (The wine example is illustrative of the time a consumer may spend looking at price of wine. We know no serious wine investor would expect to trade or make money on KC wine!)
Unlike wine, stocks are valued in earnings multiples. An investor usually will pay a multiple of 10-14 times one-year earnings for publicly traded stock indexes, with the average during a good economic time being 14 times earnings. One of the reasons for the premium (14 times 1 dollar of earnings), is that these stocks trade on a market that is considered to be one of the most liquid in the world. (Although the beverage market is liquid too!)
The Wall Street game, as one could call it, is to start the year with a large increase in earnings expectations for the year and then ratchet down this expectation throughout the year. In 2019, for example, the year began with an estimate of $200 a share earning for one share of the S&P500, which continued to be lowered, with actual earnings of the S&P500 closing the year at $174/share in Q4. The market ended the year with the index at the level of 3320 so investors were willing to pay 19X earnings for index. Quick math has the valuation multiple at the end of last year at 19X (-or approximately $20 plus for one bottle of KC Sauvignon Blanc). We don’t know about you, but we don’t want to overpay for anything. Analysts use historical data to calculate the multiple for different types of economic environments and reasonable multiples are derived from this information.
Four times a year, in the months of January, April, July and October, investors are privy to earnings season. During this time, our firm filters through earnings reports to determine the total earnings for the S&P500 for the year. It does not take a rocket scientist to deduce Coronavirus will have an effect on many companies this year; not just the airlines, travel industry and cruise ships. Last year, many on Wall Street were calling for a 7% increase in earnings growth for the S&P500 in 2020. That has shifted quickly with several analysts reducing growth to not just flat, but for a negative 5% at this point in time. According to Cantor Fitzgerald, “at a 5% earnings contraction, that places the S&P at 2460, which we believe should be a valuation-based anchor for stocks, although we know that price action typically exceeds any fundamental metric.” The math is simply 2460 divided by 16 (multiple one is willing to pay for $1 of earnings) means earnings of approx. $154 for the S&P500. At that multiple, the market is historically still overvalued, but it could be justified by the continued FED intervention in the repo market, with low interest rates and the possibility of additional fiscal and monetary policy. If the 19X multiple continued throughout the year, the index would be approx. 2900. The 2460 level on the S&P500 is simply a suggested stopping point for this year, in a down leg, in a broader correction, This is an example of how valuation works in real time and how it can change as the inputs change. At the current levels for the S&P500, the index has several additional major support levels to push through before we would see 2460. Yet, the main point here is valuations are decreasing, as are real earnings estimates. We expect this to continue as demand drops around the world due to virus concerns, social distancing and a decrease of travel, entertainment and spending.
Coronavirus has the potential to seriously reduce consumer spending which is almost 70% of U.S. GDP. It takes a lot of $20 packages of toilet tissue and Lysol wipes to equal a plane fare, a cruise, or a ticket to a major sporting, music or corporate event such as the South by Southwest Music Festival cancellation or the recent Facebook conference. This type of loss of revenue cannot be recovered. So, investors should expect earnings for the S&P500 index, (others too) to be adjusted downward as the virus and consumer spending play out in real time. It is always wise to consider valuation when making investment decisions. Following the herd is easy-sticking to a prudent plan to pay fair value helps minimize serious investment mistakes. Whining when stocks go down, after owning overvalued assets is useless. As you are out prepping for the virus, Total Wine or Costco just may provide the right valuations for your wine fridge- unless your valuation level is that of Rothschild Lafite.