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A Look At Post-Corona Market Valuations

25 Jun 2020

Dear investors,

Markets recorded another session of gains in May, with the MSCI ACWI ending the month 2.7% higher. The year-to-date loss for the index now stands at 8.3% which to many, considering the macro-economic onslaught, seems to be an underreaction of the market.  

In this newsletter, we will try to make some sense of the current valuation. The post is based on an interesting analysis done by Aswath Damodaran, a professor of finance at Stern School of Business, who has blogged extensively about the “Viral Market Meltdown”.

The bulk of his analysis goes back to the discounted cashflow model, which is classically used to value, predictable, dividend paying companies, or an index like the S&P 500. To get the value of the index, one discounts all future cash flows (dividends, share buybacks...) that investors will receive in the future back into the present. The equation is as follows:

Pre-Corona the S&P500 returned about 163$ in earnings and analysts expected these earnings to grow by about 4% annually over the next five years. In 2019 companies returned about 90% of these earnings to their shareholders in the form of dividends or share buyback programs. The discount rate is composed of the risk-free rate, which was about 1.5% before all hell broke loose, and the equity risk premium, which historically amounted to about 5%.  The first part of the equation above looks something like this:

Plugging all these figures in the first equation nets you about 3367 USD as the fair value for the S&P500, which justifies a trailing P/E ratio of about 20.

Evidently, all of these metrics have been impacted by the Corona-crisis. For instance, analysts tend to think that the effect on 2020 earnings will be devastating (-25%), but recover fast in 2021 (+30%) and recover completely by 2024. Pay-out ratios will likely follow a similar pattern, with many companies slashing dividends and share buyback programmes in the near future. The effect on the discount rate is a bit more convoluted, with the risk-free rate dropping on the one hand and ERP likely increasing from augmented levels of market volatility one the other hand. The equation changes as follows:

    

When changing the figures in the first equation to reflect the new economic reality after covid19, the fair value of the index drops to 3034 USD. Surprisingly, this means that the temporary shock in earnings only made the S&P500’s valuation decline by 10%.

The DCF model is notoriously dependent on assumptions and especially those surrounding the terminal value. As a consequence, the discount rate and growth rate of the final cashflow are extremely important. Professor Damodaran partially recognizes this problem by incorporating various probability models for the values of earnings, earnings growth, the ERP, etc. used in the equation. After running 10,000 different scenarios the professor comes up with a distribution that ranges from a mild hit to the economy (Value = 3455 USD) to a devastating blow (Value = 2277 USD).

As you can see, depending on how optimistic or pessimistic you are the current crisis seems to have a scenario for everyone… So, while the estimates may have limited predictive power, the equation is very useful as a tool to help one understand the effect of macro-economic news on the stock market. For instance, if the actions of the Fed lead to a lower risk-free rate and if they are able to ‘calm’ the markets, lowering the ERP, then it makes sense that markets trend upwards as the discount rate has dropped significantly – certainly if earnings are expected to make a V-shaped recovery.

Vector Navigator recorded a return of 2.33% during the month. Vector Flexible, which still has hedged about 65% of the market risk, returned 0.54% in May. Our market timing model does not only capture the valuation of the markets, but also builds on technical as well as macro-economic data. These latter metrics are not linked to the very loose monetary policy we’re seeing at the moment, but to the real economy, which is clearly suffering from the first wave of covid-19. This evidently causes us to be a bit more sceptical about future market prospects than the median scenario presented in the analysis above. Moreover, as portfolio managers we’re seeing numerous political risks that are hard to incorporate in any market timing model, and which we believe justifies a more cautious approach to investing.

Best regards,

Werner, Thierry & Nils