By: Ralph C. Freibert III, Chief Investment Officer
Last week ended with the S&P 500 up almost 25% closing at 2,789.82 on Thursday, the largest weekly gain in 46 years! (1) There is no doubt that my expectation of “higher volatility” presented at our Outlook event back in early February has turned out to ring true, but the reason for the volatility wasn’t even a thought at the time for most of the nation. We now know that COVID-19 was likely already spreading in the United States in January and it is now obvious the Mardi Gras holiday was a further catalyst.
Just as Mardi Gras was one of the events considered to facilitate the spread of the virus, as was the heavily populated and traveled New York. The virus has now become a catalyst to end the longest running bull market on record.
Recent infection data provided by national reporting as well as our own analysis, shows the spread of the virus appears to be slowing as a result of extreme measures by governments all over the world, and the markets have begun to rebound. The market never ceases to surprise me, as unprecedented unemployment numbers were reported with 6.6 million Americans filing last week alone, the market’s reaction was a 25-percent increase. Silly behavior? Who knows, but we have not yet seen the worst of the data being reported and I dare say equally puzzling market reaction. I have not seen any opinion that suggests we are not in a recession currently; however, the depth remains the immediate question.
It is worth repeating here that the economy and the markets, while connected are not the same. The economy leaves no room for interpretation. Unemployment is a data point. 16 million people have lost their jobs in the past 30-days. There are certainly some estimation errors resulting from counting problems, but that error is not typically a material change. Unfortunately, earnings are only accurate in retrospect and we will not see that data until after it is counted, recorded and reported. We will get a small glimpse beginning today, and the following months, as companies begin to report their first quarter numbers. However, we will not see the full magnitude of the impact until mid-June through August.
2019 recorded net earnings, of the S&P 500, was $139.47. (2) This number reflects the earnings per share of each company in the S&P 500. On December 31st, the S&P index sat at 3230, which was multiple of 23 times earnings (3230/139.47=23.16). This number is the most basic of P/E Ratios and sat much higher than the average 16.5, but there are many others such as the CAPE (Cyclically Adjusted Price to Earnings Ratio) developed by Dr. Robert Shiller. The CAPE smooths the data by using a 10-year moving average of earnings and adjusting for inflation, rather than the volatile quarterly reporting and compared to the current index value which can also be volatile. Other methods use Operating Earnings to calculate the P/E. The CAPE was 30.33 times earnings at the end of 2019 compared to the average of approximately 16.5. By any measure, the market was high compared to the average.
Now that stock prices have fallen so dramatically, how do we look, you ask? Well, that is where it gets a bit difficult. Considering the world economy has ground to a halt in many industries, we really do not know what earnings will be. As stated earlier, we will start to get an introductory look today and for the next three months. So, what you see in the form of volatility each day with the Dow up 300 points and then down 300 points the next day is merely the market reacting to each current bit of data, information and emotion.
However, the market and analysts have started is to use last year as a reference point. The market closed at 2789.82 on Thursday, as previously mentioned. If we have no change in earnings from last year in the coming year, which is not likely, the current multiple sits at 23 times earnings. That is still higher than the average, but if we have a 10% drop in earnings to 125.52 while maintaining the current multiple of 23, the market is fairly priced at 2,907 which is just above the close on Thursday. Unfortunately, that is a lot of “ifs”.
Are we not merely guessing? And if you do not know how I feel about guessing by now, you haven’t read my past articles. The reality is, if nothing else changes but the multiple goes back to the average of 16.5 times earnings, the S&P should trade no more than 2,161 which is just under the March 23rd close before the market came roaring back 25-percent. So, no guessing here! Earnings are certainly going to decline, but to what level and how long is anyone’s guess. Whether the multiple shrinks or maintains the current level is also a guess. In fact, I believe trying to guess is a fool’s errand unless you are a market trader whose time horizon is the end of the day or in the case of options, a stated day in the future. What we need to focus on is whether things will ultimately return to some resemblance of normal and the answer is most certainly yes. History has proven that we are a resilient and adaptable species.
When I was a student pilot, the instructor taught me one very important thing to always keep in mind, “don’t dip below the horizon”. That meant if I dip the nose of the plane and the horizon moves into my view, then I’m pointing down, which is not a good thing unless you are landing! This advice is just as applicable today. Let’s keep above the horizon and not look at the interim data as it comes in. Also, don’t watch the market rise and decline each day with anxiety. And finally, don’t look at your account statements with longing for the value you saw at the end of last year.
There will be many ups and downs and I would not be surprised to see us drop back to the March 23rd value of 2,237. We could perhaps see lower levels before we see some return to growth.
In 2008, the Fed pumped billions into the economy by buying securities, specifically treasuries and mortgaged backed bonds. To quote Dr. Ed Yardini, “that’s chump change” compared to what they are pumping into the market today (3). With the Fed now buying any security that needs support, that should get us through the next two months of this medical and economic battle. From there, we should see the world begin to open again and return to work, but slowly.
We have a minimum of approximately 10% or more cash in most of our client accounts. Some much more due to maturing securities. We will see these dollars put back to work soon enough at more reasonable prices.
At 9,000 feet, I had the urge to open the window of a Cessna 182 and look straight down. It was quite unsettling, and it was at that moment that I said to myself, “I never want to jump out of an airplane”. I trust you will feel compelled to make decisions about money during this medical and economic crisis. However, this is not a great time to alter plans and make long-term decisions. Don’t feel compelled to spend money needlessly but keep your eyes on the horizon and have faith that all things will work out because we have been blessed with a resilient spirit. This is true especially for New Orleanians. If we can survive Katrina and come back strong, then the country can survive this crisis and certainly come back stronger and hopefully wiser.
1 Data Retrieved on April 10th from YCharts.com
2 Data Retrieved on April 10th from YCharts.com
3 “A Billion Here, A Trillion There”, Ed Yardini, PhD, Yardini Research, Morning Briefing, April 13, 2020.
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