It is clear that stocks are implicitly reflecting pessimism about the future. How much pessimism? How realistic are the pessimistic scenarios that the market seems to be implicitly discounting?
If today’s profit margins could be sustained, if future volume growth could be maintained at historical levels, and assuming one applied the 140 year mean PE on nominal earnings, the S&P 500 (^SPX) would today be trading at a value of roughly 1,600.
Thus, according to this simple historical exercise, either stocks are significantly undervalued at current levels of 1,174 or the future will not be like the past.
Simulating Different Pessimistic Scenarios
It is possible to perform scenario analysis to see exactly what stock prices are implicitly saying about earnings expectations in the future.
I constructed a simple model that is based on the notion that investors expect things to be different for stocks in the next decade than they have been on average in the past 140 years. Specifically, the model mimics popular perceptions of what occurred in Japan during its so-called “Lost Decade.”
The model assumes some level of growth or contraction for the next five years. The following five years in the model will neither exhibit growth or contraction in earnings -- simply stagnation.
The model assumes that in year ten (2021) past historical patterns will return. From that point onward – once deleveraging runs its course and whatever else people think must occur to return to historical normalcy -- EPS will be assumed to grow at average historical rates into perpetuity. The equity risk premium will revert to historical norms. Finally, the trailing PE in year 10 will be the average for the past 140 years.
The results of the exercise are as follows:
- The current valuation of 1,174 on the S&P implies exactly 0.0% EPS growth for the next 10 years.
- A value of 1,020 on the S&P 500 implies an EPS contraction of -4.0% per annum for the next five years and total stagnation of EPS for five years after that. In the year 2021 S&P operating earnings would be around $81, or about 15% lower than they are today.
- A value of 800 on the S&P 500 implies a horrific EPS contraction of -11% per annum for five straight years and total stagnation for the next five. In the year 2021 S&P operating earnings would be around $60, or about 37% lower than they are today. This scenario jives with the sort of expectations implicit in Robert Shiller’s popular PE10 or CAPE valuation methodology (a methodology that I believe is badly flawed).
- A test of the 2009 low at 667 implies a cataclysmic earnings contraction of -16.5% per annum for the next five years and total stagnation for the next five years. Operating earnings in 2021 would be around $47, or roughly 50% lower than they are today. Indeed, this scenario implies that operating earnings will be what they roughly were in 1999. In other words, this scenario implies that S&P 500 earnings will not have made any progress whatsoever in the 22 years between 1999 and 2021.
I currently believe that all of the above scenarios for EPS growth in the next decade are overly pessimistic.
- The EPS scenario implied by a 1,020 value on the S&P 500 is remotely possible, in my view. This scenario implies a decade of global economic stagnation, no inflation and margin contraction. In other words, Japanese style “lost decade” for the entire world. Please recall that 50% of S&P 500 earnings derive from foreign sources. Thus, to hypothesize contraction in S&P earnings essentially implies an assumption of global GDP contraction for a decade. It is unlikely that this could occur under any scenario except an all-encompassing World War III.
- The scenarios implied by a value of 800 or 667 on the S&P are not even remotely realistic. Such scenarios imply a decade-long depression and deflation in the US and the world as a whole. For reasons elaborated on elsewhere, I believe that the US Fed will never allow such a scenario to transpire.
Even in a pessimistic macroeconomic scenario, I believe that S&P 500 EPS will grow substantially above the levels hypothesized above, even if for no other reason than the fact that inflation is the likely outcome of a pessimist macroeconomic outlook. Under such a scenario, nominal earnings will grow. Investors will be better served in the long-term to be in stocks in this scenario than in fixed income.
Just because it is my assessment that the earnings scenarios implied by the S&P targets above are unrealistic, that does not mean that I discard the prospect that the S&P 500 index could reach those values. Indeed, I am on record in expressing my expectations that the S&P 500 may visit the 950-1,020 range.
What the analysis above implies is that if the S&P 500 does reach those values, stocks (SPY, DIA, QQQ) would represent extremely good value, in my view. In particular, I have my eyes on stocks such as MSFT, AAPL, INTC, T, VOD, VZ, and GS.
Always mindful that new information could come to light, it is my view that investors should consider aggressively purchasing stocks if the S&P 500 reaches the 950-1,020 range.
If macroeconomic conditions were to deteriorate enough to cause such a deep correction in equities, this would imply a high likelihood of aggressive Fed intervention to prevent potential depression and deflation. Such aggressive intervention implies a significant likelihood of highly inflationary outcomes.
Under such conditions, I believe that a massive institutional asset allocation shift out of fixed income and into equities (^DJIA, ^IXIC) would put a floor under the S&P 500 (^SPX) market in the 950-1,020 range.