What can slow or stop the dramatic decline in the global equity markets and other risk assets? There are several things that need to occur, but the first is obvious: Coronavirus needs to be contained, or at least the trajectory of growth - or its “life cycle” - needs to become clearer. Many of the points I mention below might – and hopefully will - crystallise after there is clarity on the Coronavirus pandemic, so it is some cocktail of these factors that are likely to play a role in stopping this very severe downward march in the global equity markets. Let’s start with the most important factor first.
1. The trajectory of Coronavirus growth becomes more predictable. Let’s face it - Coronavirus is the big unknown. When I say in the leader that “the trajectory becomes more predictable”, I do not mean that Coronavirus fades away, because I think unfortunately that the virus is likely to spread and to infect more and more people in more and more places in the coming months. It’s happening as I write this. Furthermore, it’s hard to tell exactly what’s going on in China, where Coronavirus originated. However, assuming the data is reliable, it seems that the government has taken measures that have slowed the spread of the virus. This is encouraging for other countries that are currently seeing the number of reported cases and deaths increase. Buying time is perhaps the best we can hope for, providing some space for the development of more potent medicines to treat those that have been infected, and ultimately, a vaccine. From the perspective of investors, I do not think that Coronavirus needs to be eradicated per se before volatility subsides and a floor can be found that is supported by corporate earnings. Before investors can begin to feel some comfort though, they must be in a position to better grasp the “bid-ask” of the trajectory - or perhaps the worst-case scenario – so as to price risk assets with more confidence. At the moment, the future path of Coronavirus remains vague at best, so investors feel for floor valuations is equally squishy. This uncertainty is exerting maximum selling pressure on stocks and other risk assets.
2. Targeted Fiscal Stimulus. The most affected and / or proactive countries need to develop targeted fiscal stimulus plans, which have already been announced and implemented in several countries such as the U.K., China and Italy, as well as by the IMF and World Bank. It is probably the most important factor that will contribute to stabilisation in the early stages of the Coronavirus pandemic as governments try to stabilise their economies and mitigate the downside effects. I suppose the word “stimulus” in this case is not the correct description – drastic measures must be taken to simply stop the bleeding as economies unravel. Ideas range from personal tax breaks / deferrals to governments stepping in and providing loans (or private sector loan guarantees) to ailing industries or companies that are short on liquidity because their business has ground to a halt. The U.K. and other countries have already announced similar programmes to effectively provide bridge financing to SME’s that might otherwise run out of cash as their revenues plummet.
3. Energy Prices Decline and Stay Low for Some Period of Time. The dramatic fall in energy prices seems to have strangely been the blame for some of the equity market volatility and overall market declines. Aside from those companies involved in the exploration or production of oil & gas, including the large major oil companies and many smaller independent oil companies scattered around the world, lower oil prices for most companies are in effect a fiscal stimulus. For reference, the energy sector accounts for only 5.4% of the S&P 500, so the fact that these stocks are getting hammered shouldn’t drag down the entire universe. In fact, ss oil prices fall, companies pay less for energy, improving their cash flows and earnings. Consumers pay less for petrol and – if applicable - for heating and /or cooking. As such, the cost base of energy-dependent companies will be reduced improving their cash flow, and consumers should have more disposable income to spend. Both of these should provide a form of legitimate fiscal stimulus to the economy. Strangely – at least to me - the negatives associated with much lower energy prices seemed to have far out-weighed the positives over the last few days.
4. Valuations move in line with historical averages. Inflated valuations have been a concern for several months now, well before Coronavirus hit the screens. Equities and the indices were moving higher at a faster pace than earnings, when in fact earnings have been slowing in the U.S. for several quarters now (albeit still growing). Using data from multpl.com, I calculated that the average monthly P/E for the S&P 500 over the last 10 years (120 months) has been around 20x. (Note that the last six monthly readings are estimates.) The aggregate S&P 500 P/E reached a peak of 25x on February 1st of this year, well above the 10-year average. The harsh sell-off in equities has caused the P/E ratio of the S&P 500 to fall to round 20.6x as of yesterday, so we are re-approaching the 10-year average as far as valuation. However, I will caution the reader that the denominator – earnings - is a trailing figure, and earnings are of course going to decline over the next few quarters as the economy stagnates. How low should the P/E ratio go before rational thinking sets in? For context, the lowest P/E ratio for the S&P 500 since the Great Recession occurred in the autumn of 2011 when the P/E ratio fell to 13.5x. It has steadily climbed since then reaching 20x at the beginning of 2015. There is a long history of P/E ratios (see link above) but it is a somewhat nuisanced history that needs much more explanation than I am able to provide in this post to fully understand it. Also, given the trailing nature of earnings, perhaps a more relevant ratio is the forward looking P/E ratio, which was at 19x or so pre-Coronavirus and is now 16.8x – see Exhibit 5 of Yardeni Research here.
5. Earnings growth – the new reality needs to come into focus. Earnings growth was negative for the S&P 500 between 1Q2014 and 3Q2016 as the U.S. economy endured a difficult patch. However, earnings have grown every quarter since then, averaging 15.4%/quarter compared to the same quarter of prior year, an impressive run (source: multpl.com). Still, earnings growth has been slowing since 4Q2018, and now forward guidance will inevitably be adversely affected by Coronavirus in the first and second quarters of 2020 – and perhaps beyond. Apple was really the first company to come clean, but they have been followed by many other companies, with some sectors – e.g. travel, airlines, hotels, shipping, leisure generally, etc. – being much more adversely affected. With an uncertain outlook for earnings, it becomes very difficult to compute the denominator of a forward-looking P/E ratio, and this in turn makes valuations difficult. This is very related to the path of Coronavirus, including the length of the crisis and the severity. Only when companies can better project their earnings in this new environment will investors be able to get a better grip on valuations.
6. Dividend yields vs bond yields. The graph below from multpl.com shows that the dividend yield on the S&P 500 has steadily worked its way down over many years before stabilising at around 2%/annum in 2010, following the Great Recession. (Note that this is a very long history but what matters most is the recent history.)
As stock prices increased, the yield on the S&P 500 fell to 1.83% at the end of 2019, but the recent sell-off has pushed the yield back out to 2.12%. This has to be put in the context of corporate bond yields. Average yields on U.S. corporate BBB-rated bonds have decreased from nearly 10% at the peak of the Great Recession to 4% by mid-2012. Since then, average yields on BBB-rated bonds have largely bounced around between 3-1/4% and 4-3/4%, although the trend recently as concerns about risk subsided in the market had been down as yields fell below 3% in late January. Yields continued to tighten in February, bottoming at 2.63% mid-month before recently widening to 2.95%. For reference, I suppose we could say that the loose correlation between dividend yields on stocks has been about one-half of the yield on BBB-rated bonds over the last few years. However, with earnings growth expected to become negative in the coming quarters, dividend levels will be at risk for many companies which might choose to reduce their dividends in order to conserve cash. Having said this, the situation is very company-specific, and I would expect that astute investors might decide – in some cases - that they would prefer owning the potentially more volatile stock of a company with a dividend yield above the same company’s bond yield, thereby getting more current income (from owning the stock) alongside some upside from potential stock appreciation. I have more work to do on this point.
7. Investor Psychology – Transition Back from Abyss. There’s no doubt that psychology has played a big role in the very violent swings both ways in the equity markets. FOMO (“fear of missing out”) and mispriced (and cheap) credit drew investors into the equity markets that had taken on a “teflon feel” of going only in one direction forever, which was up. However, even greater fear as market conditions turned harshly bearish have caused investors to dump shares in droves, perhaps many from index funds. I suspect this behaviour will continue to exacerbate downside movements, as investors vote with their feet and exit the very market that - over long periods of time - still offers the best risk-return reward. Moreover, the psychology is worsened by what are almost certainly a slew of FOMO investors that relied on margin loans and credit to go big into the market. These very same investors are now facing margin calls and have become forced sellers, exacerbating the downturn. As history has shown, this too will run its course as panicked investors run for cover, eventually allowing more experienced and less nervy investors to pick through the remains and find value. As volatility subsides and investors settle down, the cycle will of course start again.
8. M&A Activity. There are plenty of acquisitive companies sitting on piles of cash that must be looking at the price of potential targets falling quickly. Aside from corporate activity, we can also anticipate more private equity activity assuming the credit markets stabilise and financing is available (which it arguably is not at the moment). Private equity firms were estimated to have around $2.5 trillion (from FT, June 27 2019) of “dry powder” to invest, and must have their sights set on plenty of interesting LBO candidates as these companies become cheaper by the day.
As corporate M&A activity and private equity-led LBO’s eventually begin to accelerate, this will inevitably provide some more concrete valuations of companies in the sectors in which acquisitions are occurring. However, I would expect that the Coronavirus pandemic will need to have been brought under control before this activity becomes more widespread.
9. Stock Buybacks. For companies that are not M&A focused but that are sitting on cash, perhaps they need to look nowhere further than their own shares as an investment for excess cash to provide value to their shareholders. Perhaps not surprising, companies have been taking advantage of growing cash balances - perhaps much of which was fuelled by nearly free credit caused by artificially low borrowing costs - to fund stock buybacks. Look at this graph from Standard & Poor’s, courtesy of Yardini Research (Figure 5).
📷
The first thing that this graph shows is that dividends are much less likely to be reduced during a downturn (see period 2008-2009), but stock buyback programmes get binned almost immediately during an economic crisis. However, stock repurchases come back into focus rather quickly as markets stabilise and companies view their own shares as a viable investment. These sorts of buybacks essentially “floor” the market price of a company’s shares, as the companies themselves can often become a very influential buyer in the market.
In conclusion, we are in unchartered waters these days. We can only hope that through some combination of the Coronavirus end-game coming into focus, targeted fiscal stimulus in the meantime, investors becoming more rationale, earnings and valuations becoming more reliable, and perhaps several of the other steps mentioned in this post, can we discover a bottom in equity prices. At the moment, we appear nowhere close as equity prices continue to gap down at an alarming pace.