My Latest Thoughts on the Stock Market

​In the past month, we have seen the S&P 500 drop 32% from its all-time high on February 19th.  As it is happening real time, it feels like something that has never happened before.  The average market decline for a recession is 30% so the magnitude of the drop (so far) is very normal.  The difference this time is it happened in record time.  This is the fastest move from record high to bear market in history.  You also have a long list of stocks that are down well over 50% or even 80% in the recreation, energy, and restaurant industries.  The more debt a company has, the bigger the decline in the stock price.  This tells you survival for many companies has become more important than growth or profitability.  There is a dramatic shift in focus now from the income statement to balance sheet.

Although the magnitude of this decline is normal, the emotional impact is more significant because most of us are focused on the Coronavirus and all the uncertainty that comes with it.  As much as possible, we need to remove emotion from the investing process.  Emotional investors rarely beat the market.  Instead they fall victim to fear and greed.  They buy stocks at all time highs because everyone around them is excited about the market or they buy at all time highs over FOMO (fear of missing out) and then repeat the mistake by selling after a significant decline because they just can’t take the pain anymore.  Everyone has heard buy low and sell high.  It’s a simple concept but it goes against the way we are wired.
 
My approach to removing as much emotion as possible is to focus on the numbers.  You know from my past blogs I felt the market was expensive and therefore, would not deliver decent long-term returns.  When markets are expensive and priced for perfection and something less than perfect comes along, they eventually correct.  We just don’t know the cause ahead of time. 
 
If markets are cheap and a negative event occurs, the cheap market will go down as well but not nearly as much because value investors will be jumping in to buy.  In this case, we are moving from overvalued to more fairly valued - not fairly valued to undervalued.  When I make these comments, I am referring to the broad market (S&P 500).  There are plenty of individual names that are undervalued now.
 
So, let’s remove emotion and look at some numbers….
 
The March 20th close on the S&P 500 was 2305.  This is a decline of 32% from the all-time high and a decline of 22% from a year ago. From the low in 2009, the market is still up 246%. 
 
One simple approach to determine a fair value for the market is to apply a Price/Earnings ratio to 2020 earnings.  Latest estimates for the S&P (before COVID 19) according to FactSet Data were $175.  If you apply the long-term avg P/E of 16.5, you get a fair value of 2888 for the S&P 500.  This tells you half of the recent decline (15 percentage points) from the high of 3394 was simply taking us back to a more reasonable valuation, even without the virus. Nobody knows what the virus impact will be because it is totally dependent on severity and duration.  If we look at the six largest earnings declines since 1980, the average has been 26%.  It would be easy to argue this one will be worse than the average decline, but it really depends on duration.  If we have a modest drop in Q1, a significant drop in Q2, followed by a recovery in Q3 and Q4, this assumption might be reasonable.
 
      2019 earnings according to FactSet Data = 163.02
      2020 earnings decline estimate =                   -26%
      2020 earnings estimate   =                            120.63
 
      Earnings $120.63 x P/E 16.5 = S&P 500 of 1990 (14% below today’s level)
               
The approach I prefer is to determine normalized earnings that smooth out peaks and valleys.  If you value the market based on record high profit margins like we had going into 2020, you end up overstating fair value.  In contrast, if you take earnings in a recession, you understate fair value.  2009 was a great example.  Earnings were down significantly which made the market look expensive on a P/E basis.  In reality, it was the buying opportunity of a lifetime which is why you need to be careful when deciding which period to use.
 
I will spare you all the math, but I like to look at average earnings over a complete cycle.  Normally, I use a 10-year average, but we have not had a recession in over 10 years, so I am currently using a 12-year period (2008-2019) to capture the previous recession. I also adjust the historical earnings by inflation to bring everything to today’s dollars. This gives us a “normalized” earnings figure for the S&P 500 of $122.26. 
 
      Earnings $122.26 x P/E 16.5 = S&P 500 of 2017 (13% below today’s level)
 
My point here is this correction feels more like a movement from overvalued to more appropriate value, but I would not consider it a screaming bargain like we saw in 2002 or 2009.  Again, these comments relate to the total market, not individual names where there are plenty of opportunities.  Personally, I focus more on individual companies and prefer to ignore what the overall market is doing.  Most people I know invest in mutual funds and exchange traded funds, so I wanted to provide a total market perspective. 
 
I realize I have not answered the critical questions most people have:
 
1)How long will this last?
2)How much lower is the market going?
3)Should I sell?
4)If I sell, when should I buy?  
 
 Nobody has these answers, nor do you need them to be a successful investor.  The people who give specific answers to these questions are normally being paid to have the answers, so they feel obligated to provide them.  The quote from John Kenneth Galbraith applies here: “There are two kinds of forecasters.  Those who don’t know, and those who don’t know they don’t know”.  You are placing an unreasonable demand on yourself if you feel you need specific answers to these questions in order to invest wisely.  The question you should be asking yourself is: What is a reasonable value for the market and how does that compare to current prices.    
 
 
 
 
Questions or comments, feel free to email me at [email protected]
 
 
 
 
 
 
 
 
 
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