Down to Earth


There have been some surreal COVID-19 market reactions, including negative oil prices and gravity defying equity valuations. As analysts adjust their earnings growth forecasts in line with pessimistic economic predictions, we should prepare for more market volatility.

This COVID-19 crisis has brought the surreal to our everyday lives in many ways. Perhaps the most surreal financial market manifestation has been the collapse in oil prices. At the start of this year, the US crude oil benchmark, West Texas Intermediate, traded above $60. Before the expiry of the April futures contract, that price had fallen to minus $37 as producers literally paid buyers to take the oil. As we learn of the shocking rise in unemployment in the US, we also note the surreal gap emerging between the economists’ expectations of the economic loss resulting from lockdown and equity market fantastical evaluations of the same.

In this piece we pull at that gap and note that either economists have become too pessimistic or that equity valuations need to come back down to earth.

Last week the International Monetary Fund (IMF) published their latest World Economic Outlook and their economic forecasts for this year and next (Figure 1). The forecast for global growth was particularly alarming, showing a contraction of 3%. That would be more than three times the scale of contraction predicted in their November 2008 forecast in the wake of the Lehman failure. Forecasts for global growth are almost always positive. The expected extent of the global synchronization to this slowdown could be a first. The IMF have also forecast the US to contract by nearly 6% this year, more than double the size of the contraction experienced during the last recession (Figure 2). While an expected recession may no longer be a surprise, the scale of the likely lost output really is quite alarming.


Figure 1: IMF Economic Forecasts


To contrast these gloomy economic predictions with equity market valuations would seem to be a natural next step.

The equity market low on 23 March this year, when the S&P 500 fell to 2,237.4, represented a peak to trough adjustment of 34%. The equity recovery rally over the past few weeks has eaten into that adjustment such that it now represents a peak to trough adjustment of just 17%. The last recession generated a fall of 57% measured on the same basis. The valuation adjustment was also more challenging, with the S&P trading on a price to earnings (PE) multiple of 19x prior to the recession, falling to less than 10x earning afterwards. Through lockdown, the equity market has fallen from around 20x earnings to 15x on a historic PE basis. Nothing like the valuation adjustment from the last recession.

Figure 2: US Versus World GDP Growth


So why then are we seeing this gap between economic expectations and equity market-based expectations?

Historically there has been a very strong relationship between Gross domestic product (GDP) growth and earnings expectations (Figure 3). To place that into context, the 10% fall in earnings growth expected by analysts would normally be consistent with positive economic growth and not a recession (Figure 3 right hand scale). Looking at this relationship slightly differently, the 4% annual fall in GDP growth (measured on the quarterly data) seen at the worst of the last recession was associated with a 40% plus fall in earnings growth. The disconnect is not just between equity markets and economists, but equity analysts too. Figure 4 plots annual equity returns versus earnings growth forecasts plotted on a more granular daily frequency. It is clear that equity returns are in line with analysts’ earnings growth expectations, but not the IMF.


Figure 3: US GDP Grwoth Versus I/B/E/S 12m Forward EPS Growth


Either the IMF and other supranational agencies are way out with their forecasts for GDP growth, or equity markets and analysts have some catching up to do. Now don’t get us wrong, we realise that economists are there to make weather forecasters look good, but the historic bias from the supranational agencies such as the IMF has been to the upside. Economists, like analysts, have historically been too optimistic, not too negative, on growth.

Another way of pulling at this conundrum is to estimate the market implied medium-term growth rate (Figure 4). We have used I/B/E/S consensus earnings forecasts for the next five-years and assumed a terminal growth rate in line with twenty-year average nominal GDP growth rate, and an equity risk premium of 5% added to the risk-free term structure.


Figure 4: S&P 500 Annual Returns Versus I/B/E/S Earnings Growth Forecasts 12m Forward




Figure 5: S&P 500 Market Implied Medium-term Growth %


Pushing all of that into a three-stage Dividend Discount Model (DDM), we can estimate the market implied growth rate for years 5-15. That implied estimate fell to -3% earlier this month, before analysts revised down further their earnings expectations. The implied growth rate is now closer to -1%. To have no growth in earnings over the medium term, 2025-2035, would be highly unusual.

This would suggest that both analysts and the market are still expecting too much over the short term, and particularly this year and next. So, as analysts come back down to earth, unless equities have hitched a ride on a magic carpet, we should expect some fallout from markets too.



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