Yardeni on S&P 500 Earnings, Valuation, and the Pandemic: Part III

This three-part series is excerpted from my 2020 book S&P 500 Earnings, Valuation, and the Pandemic (co-authored with Joseph Abbott). Part I (Earnings): Introduction. Discounting Forward Earnings. Lots of S&P 500 Earnings Measures. Revenues, Earnings & Profit Margins. Part II (Valuation): Flying with the Blue Angels. In the Eyes of the Beholder. Reversion to the Mean. Fundamentals Matter. Discipline of Dividends. Part III (Pandemic): Very Useful Indicators. The GFC and the GVC. Fed-Led Valuation Meltup. Epilogue. 

Part III: Pandemic

Very Useful Indicators

In Part I, we observed that both forward revenues and forward earnings of the S&P 500 are very useful economic indicators because they correlate so well with lots of leading and coincident business cycle indicators in the US. They have been especially useful because they have been available weekly since mid-January 2006 for forward revenues and since the end of March 1994 for forward earnings.

Focusing on forward earnings, we see that during the six economic recessions since the late 1970s, it peaked just before the start of the downturns and bottomed near their troughs (Fig. 44). Forward earnings also confirms that there was a mid-cycle growth recession during 1985 and 1986. While there was a sharp selloff in the S&P 500 during October 1987, forward earnings continued to rise through 1989. The bull market of the 1990s was supported by a long uptrend in forward earnings. Forward earnings remained relatively flat following the recession of 2000 to 2002, but then it proceeded to make new record highs, as did the S&P 500, through late 2007. The next year found forward earnings tanking during the Great Financial Crisis (GFC).

A V-shaped recovery in forward earnings started in early 2009. The metric rose to a new record high during May 2011, after which its pace of rise slowed through mid-2014. It then stalled through mid-2016 as a result of a global economic slowdown.

But it started moving higher again at a quickening pace through 2017, signaling a pickup in global economic growth. It got another boost in early 2018 when the corporate tax rate was slashed from 35% to 21%. As increasing trade tensions between the US and its major trading partners, particularly China, slowed the global economy, forward earnings stalled once again during 2019 through early 2020. Then the Great Virus Crisis (GVC) hit.

The GFC and the GVC

Now let’s turn to how we used the analytical framework discussed so far to analyze and predict the likely impact of the GVC on the stock market equation. To do so, we benchmarked our outlook to the performance of forward revenues and earnings during the GFC.

The GFC to a large extent was a typical business-cycle downturn. It was preceded by an economic boom that was led by speculative excesses, particularly in the housing industry. When that bubble burst, a credit crunch worsened the resulting recession, with real GDP falling 4.0% from the fourth quarter of 2007 through the second quarter of 2009. The Dating Committee of the National Bureau of Economic Research (NBER) ruled that it lasted 18 months, from December 2007 through June 2009.

The collapse of Lehman Brothers on Monday, September 15, 2008 was the most calamitous event that exacerbated the GFC. The S&P 500 had dropped 20.0% from its October 9, 2007 record high through the previous Friday close. The index was experiencing a garden-variety bear market up to that point. It turned into a great crash after Lehman failed, with the S&P 500 plunging another 46.0% through the bear market’s bottom on March 9, 2009. The results were a global credit crunch and a severe global recession.

The declaration on March 11, 2020 of a pandemic by the World Health Organization (WHO) precipitated the GVC as governments around the world locked down their economies to slow the spread of the virus. The result was a severe global recession, as evidenced by freefalls in world production and in the volume of world exports comparable to the experience during the GFC.

However, the GVC is unique. In many ways, it’s like a major natural disaster that hit the entire global economy. Initially, it did trigger a credit crunch as a pandemic of fear spread through the financial markets causing a mad dash for cash, which caused credit-quality yield spreads to widen dramatically and depressed stock prices. But the world’s major central banks quickly halted the credit crunch by pouring lots of liquidity into global financial markets.

The NBER’s Dating Committee determined that the US economy peaked during February 2020. Real GDP dropped 10.6% from the fourth quarter of 2019 through the second quarter of 2020. Numerous economic indicators bottomed during April as governments around the world started to ease lockdown restrictions. That would make it a two-month recession. A recession that short and severe is unprecedented, but that’s because there is no precedent for a recession caused by government-mandated lockdowns around the world implemented to slow the spread of the virus.

We first sounded the alarm about Covid-19 in our Tuesday, January 28, 2020 Morning Briefing titled “Something to Fear.” We wrote:

"Until Friday [January 24], there was nothing to fear but nothing to fear, other than historically high valuation multiples. Since Friday, there has been something else to fear: that the coronavirus outbreak in China is spreading rapidly and turning into a pandemic, i.e., a global epidemic. The S&P 500 dropped 0.9% on Friday and 1.6% yesterday. The most unsettling news over the weekend was that people infected with the virus might show no symptoms for two weeks but still be contagious during that time."

The asymptomatic nature of the virus was our biggest concern compared to previous pandemics.

Nevertheless, the S&P 500 rebounded and continued to rise to a record high on February 19 (Fig. 45). That very same morning, our commentary was titled “In a Good Place?” We observed that during his semi-annual congressional testimony reviewing monetary policy on February 11 and 12, Federal Reserve Chair Jerome Powell emphasized that the “US economy is in a very good place.” The threat from the coronavirus is something to watch, he said, but too early to understand. Nevertheless, he affirmed that “there is no reason why the expansion can’t continue.” We wrote: “We wish he would stop using that expression [i.e., “in a good place”]. Our contrary instincts come out every time he says it.”

From its record high on February 19, the S&P 500 proceeded to plunge 33.9% through March 23. On February 25, we wrote that the “Fed may need to deliver a couple more rate cuts to keep the US economy in a good place.” Sure enough, the federal funds rate was cut on March 3 by 50 basis points to a range of 1.00%-1.25%.

We observed that a pandemic of fear was spreading in the financial markets faster than the viral pandemic. We started to write about the “mad dash for cash,” as evidenced by soaring holdings of liquid assets, rapidly widening credit quality spreads, and big outflows from bond mutual funds. In Zoom conference calls with our accounts, many told us that they wanted to rebalance their portfolios by selling some of their bonds and buying more stocks as they got cheaper, but the credit markets had frozen, making it very difficult to sell bonds without taking a huge hit.

The financial markets continued to melt down after the WHO officially declared the pandemic on March 11. On Sunday, March 15, the Fed held an emergency meeting of the Federal Open Market Committee and announced that the federal funds rate would be slashed by 100 basis points to 0.00%-0.25%. In addition, the central bank committed to a fourth program of quantitative easing (QE4) to purchase $700 billion of US Treasury and mortgage-backed securities.

On Monday, March 16, the S&P 500 dropped 12%. That partly reflected a vote of no confidence in the Fed’s response to the pandemic. The Fed seemed to be running out of ammo for its monetary bazookas. Instead of having a shock-and-awe impact, the immediate reaction to the Fed’s March 15 actions the next day was more like “aw-shucks!”

To be fair, that same day President Donald Trump pivoted from saying that Covid-19 was like a bad flu to saying that we should stay home if our state governors ordered us to do so. That was the gist of the new guidelines issued by the White House that day “for every American to follow over the next 15 days as we combat the virus.” The governor of California issued a stay-in-place order on March 19; New York’s governor followed on March 20, and the rest of the states’ governors did the same over the following few days.

The stock market continued to fall, and credit-quality spreads soared. The Fed responded on March 23 with an open-ended commitment to buy US Treasury and mortgage-backed securities, and even to buy corporate bonds for the first time ever. We called it “QE4ever.” The Fed had junked the bazookas, skipped the helicopters, and gone straight for the B-52 bombers to carpet-bomb the economy with cash. In our March 25 morning commentary, I wrote:

"Yesterday’s big rally in the stock market followed the Fed’s announcement on Monday morning that QE4 was no longer limited to $700 billion but could extend to infinity and beyond. The Fed has turned into the Bank of Japan, offering an open-ended commitment to buy almost every financial asset forever, including investment grade corporate bonds. Joe and I think that Monday might have made the low in this bear market."

We predicted that the S&P 500 would be back in record-high territory during 2021. We didn’t expect that it would get there by August 18, 2020, which is what happened. We observed that the year started out with investors still reaching for yield in the credit markets. The pandemic of fear quickly caused their mad dash for cash. Now after QE4ever, we sensed a mad dash back into equities.

Following the WHO’s declaration, we anticipated that analysts’ S&P 500 consensus earnings expectations for 2020 and 2021 would freefall, bottoming by the middle of 2020, as we assumed that the lockdown restrictions would be gradually lifted by then. We also observed that because the GVC started in early 2020, investors would be giving more weight to 2021 expectations as 2020 progressed, as best measured by forward revenues and forward earnings; accordingly, as long as analysts expected a recovery by the coming year, both measures would likely bottom by mid-2020 and recover over the rest of the year through 2021.

On the other hand, the GFC worsened significantly near the end of 2008 following the collapse of Lehman. So it significantly depressed 2009 expectations for revenues and earnings. As a result, forward earnings didn’t bottom until the week of May 8, 2009. That was 33 weeks after Lehman imploded. This time, forward earnings bottomed 10 weeks after the March 11 pandemic declaration (Fig. 46).

The stock market downdraft was longer and deeper during the GFC too. S&P 500 fell 56.8% from its October 9, 2007 then-record high through March 9, 2009. This time, during the GVC, the S&P 500 dropped 33.9% from its then-record high on February 19, 2020 through March 23. It then rose to a new record high on August 18 and continued to rise through September 2, 2020 when we finished writing this primer.

Fed-Led Valuation Meltup

The surprise during the GVC was the big jump in the S&P 500’s forward P/E from 12.9 on March 23 to 23.2 on September 2. With the benefit of hindsight, it all makes sense. The Fed’s extraordinary policy responses to the GVC lowered the 10-year US Treasury bond yield below 1.00%. Credit-quality spreads narrowed significantly, resulting in record-low yields in investment-grade and high-yield corporate bonds. The forward P/E soared as investors scrambled to rebalance their portfolios out of bonds and into stocks. As a result, investors paid higher valuation multiples for stocks as yields fell closer to zero. The forward P/E soared along with the Fed’s balance sheet (Fig. 47).

In our June 8 Morning Briefing, Joe and I observed that the stock market rally since March 23 could turn into the Mother of All Meltups (MAMU). Sure enough, since March 23 through September 2, the S&P 500 rose 60.0% to a new record high of 3580.84. It did so in 163 calendar days. The tech-heavy Nasdaq was up 75.7% over the same period, also to a new record high, of 12056.44.

The last time that the S&P 500 rebounded so much in such a short period was during September 1933. While the Nasdaq’s rally was impressive, it paled by comparison to the 255.8% meltup from October 8, 1998 through March 10, 2000; but it was on the same trajectory as it was back then.

The forward P/E of the S&P 500 jumped to 23.2 by September 2, approaching its highs during the tech bubble of 1999. The forward price-to-sales ratio of the S&P 500 rose to 2.5 that same day, the highest on record.

Since late March, the stock market was working on answering the question that Joe and I started to ask as the meltup proceeded: “In a world of zero interest rates, what is the fair value of the S&P 500 forward P/E?” Taking our cue from Hamlet, we were simply asking whether stocks should be deemed to be or not to be too expensive when the federal funds rate is zero and the 10-year US Treasury bond yield is less than 1.00%, as both had been since the second half of March.

The market’s answer was that stocks remained cheap as long as interest rates stayed near zero. The longer that was the case, the cheaper stock prices appeared to be, and the higher they might potentially go. On August 27, Fed Chair Jerome Powell did his best to convince market participants that interest rates would stay close to zero for a very long time. He said so during his speech at the annual meeting hosted by the Federal Bank of Kansas at Jackson Hole, Wyoming. He officially declared that the Fed no longer was aiming for a 2.0% bullseye on the inflation target but rather for an average around it.

The 2.0% target was officially declared by the Fed in January 2012. During the 102 months since then through July 2020, the headline and core PCED (personal consumption expenditures deflator) inflation rates averaged 1.4% and 1.6%, rarely hitting the mark and consistently going below it. Since January 2012 through July 2020, the PCED has been tracking an annualized growth rate of 1.3%. As a result, it was 5.2% below where it should have been had it been tracking the Fed’s 2.0% target. To get back on the 2.0% inflation rate track since the start of 2012 certainly left the Fed with plenty of room to tolerate a pickup in inflation without even “thinking about thinking about raising [interest] rates” under the new average-inflation-targeting (AIT) approach (quoting from Powell’s July 29 press conference).

Notwithstanding Powell’s dovishness, bond yields initially rose in response to his speech. Investors seemed more concerned about the inflationary consequences of AIT than about the prospect that the federal funds rate will remain around zero for a longer time under the new regime. However, the fact that the Fed has failed to get inflation sustainably up to 2.0% since January 2012 raises the question of why the Fed would be any more likely finally to do so simply because it has declared that overshoots will be tolerated. In any event, if the bond yield continues to move higher, the Fed would likely adopt a policy of “yield-curve targeting,” which is a fancy term for pegging the bond yield in a narrow range close to zero. In that scenario, the meltup in stock prices certainly would continue.

So again, we ask: In a world of zero interest rates, what is the fair value of the S&P 500 forward P/E? The market’s answer at its then-record high on September 2 was as follows:

? S&P 500 forward P/E. The S&P 500’s forward P/E on Wednesday, September 2 was 23.2, up from 12.9 on March 23. The last time it was this high was February 1, 2001, when the 10-year bond yield was 5.10% and the PCED inflation rate was 2.6%. The bond yield was down to 0.66% on September 2. July’s PCED inflation rate was 1.0%.

? S&P 500 Growth vs Value forward P/E. As of the September 2 close, the forward P/E of the S&P 500 Growth index rose to 30.2, up from the March 23 low of 16.8 (Fig. 48). The latest reading is the highest since January 2001, when the bond yield was 5.16% and inflation was 2.6%.

The forward P/E of the S&P 500 Value index also jumped from 10.0 on March 23 to 17.4 on September 2. Interestingly, the ratio of the forward P/Es of Growth to Value has been on an uptrend since early 2017, and was at 1.74 on September 2, which is still well below this ratio’s July 2000 bubble peak at a reading of 2.67. Meanwhile, the ratio of the forward earnings of Growth to Value had spiked higher since the start of 2020, justifying the widening P/E spread between the two.

? S&P 5 vs S&P 495 forward P/E. Leading the charge higher among the S&P 500 were the S&P 5. The Magnificent Five are the so-called FAAMG stocks (Facebook, Amazon, Apple, Microsoft, and Google). On September 2, they accounted for a record 27.2% of the market capitalization of the S&P 500. The market-cap share of the comparable S&P 5 during the tech bubble peaked at a then-record high of 18.5% during March 2000 (Fig. 49).

Collectively, the forward P/E of today’s Magnificent Five rose to 44.6 on September 2 (Fig. 50). That might be justified by their ability to grow their forward revenues and earnings faster than the S&P 495 in a world of zero interest rates. By way of comparison, just before the S&P 500’s tech bubble burst during March 2000, the sector’s forward P/E peaked at 48.3, while the bond yield was 6.26% and inflation was 2.9%.

Just before we went to press, the S&P 500 sold off sharply after it hit its latest record high on September 2. The drop was led by the Magnificent Five, indicating that investors believed that they had been overvalued and that taking some profits made sense. Joe and I agreed and concluded that the selloff was a healthy correction. We hoped that the S&P 500 might stall, consolidating its gains since March 23 at least through the November 3 elections. That would give earnings some time to catch up with the stock market’s rally. Before the market resumes its climb, investors might want to see more progress on the vaccine front, how the elections play out, and which letter of the alphabet best resembles the shape of the economic recovery. On the other hand, we didn’t rule out the possibility of another 1999-style meltup.

While the stock market equation is a very simple one, there are always lots of factors that influence the outlook for earnings and the valuation of those earnings.

Epilogue

We hope that our primer on the stock market equation is a useful contribution to a more structured understanding of the forces that drive the stock market.

Collectively, earnings tend to grow around 6% per year on average over the long run. In the short run, they tend to be procyclical, which means that they grow when the economy is growing and fall when the economy is heading into a recession. The market discounts analysts’ consensus estimates for revenues and earnings this year and next year on a time-weighted basis. Calculating weekly forward revenues and forward earnings from analysts’ estimates can provide very timely insights into the performance of the global economy as well as the underlying trends in quarterly revenues and earnings.

While we believe that our framework provides a disciplined approach to analyzing the macroeconomic fundamentals that are driving earnings, the valuation of those earnings by investors will continue to be much more subjective than objective. Nevertheless, there are fundamental factors that influence valuation multiples. Some, like inflation and interest rates, will always be important in assessing the valuation question. Other factors may be relatively new and worthy of careful analysis.

Long-term investors who purchase stocks when they are fairly valued can reasonably expect that S&P 500 earnings will continue to grow at its historical 6% annual rate. The S&P 500 closed at 3580.84 on September 2, 2020. A 6% annual appreciation rate, matching the growth rate of earnings, would take the index to 6168 by the end of 2029, a gain of 72%. That return will be higher or lower depending on whether the valuation multiple is higher or lower by the end of the decade than it was on September 2, 2020.

The S&P 500 has delivered solid returns for long-term investors in the past. It should continue to do so in the future.

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Copyright ? 2020 Edward Yardeni. All rights reserved. No part of this publication may be reproduced in any form or by any electronic or mechanical means, including information storage and retrieval systems, without permission in writing from the publisher, except by reviewers, who may quote brief passages in a review. ISBN: 978-1-948025-08-9 (paperback) ISBN: 978-1-948025-09-6 (eBook)

Part I: Earnings .......... Part II: Valuation .......... Part III: Pandemic