It’s a psychological fact that market falls are almost always painful. But stock market rallies can be almost as hated if they take a lot of people by surprise which is the same as saying the narratives in play against it are stronger or more prevalant than those supporting it. The bounce we’ve been in since 23 March has been called the most hated bull market ever, that probably has a lot to do with the stark contrast between it and the public health emergency. Look, I’m no stock analyst so I can’t give you an informed view on where earnings are going. But I am an actuary which means I do know one little awkward fact that actuaries and pensions people are familiar with – hear me out!
When discounting a steam of cash-flows far into the future, the present value is annoyingly sensitive to the discount rate used. It’s really irritating! Far more so than the sensitivity to the early cash-flow values – these can fall substantially, even evaporate entirely and hardly change the present value. This gets missed in comparisons of P/E or CAPE ratios or discussions of V or U shaped recoveries.
That’s a mathematical fact (bear with me, I’ll show you) but does it tell us anything useful about the equity market?
Well, the 30%+ bounce in the S&P 500 and other indices off the late March lows has rightly been labelled the fastest bounce in the history of bear markets , on average we’d expect such recoveries to take a lot longer. On average bear market recoveries take 5 years (even “event driven” bear markets take a couple of years to recover on average). And many have asked whether, with the S&P 500 back above the 3,000 mark, close to where it was at the start of the year, is the rally overdone? Is the stockmarket divorced from reality?
The Economist jumped on this narrative from early May. But it's always important to remember that the stock market is NOT the economy.
No-one knows this for sure, or course, and whatever most market participants think by definition is quite likely to end up being the case. But I can offer you a plausible explanation for why the answer to this might be “no”.
Taking inspiration from a neat paper by authors at DWS earlier in the year, we can build a simple (embarrassingly simple in fact) DCF model for equities without knowing anything at all about the actual earnings. This relies on a neat trick that what matters in markets is what happens relative to what was priced at a point in the past.
All we do is look at the future earnings stream relative to what it was at the start of this year. So think of an index stretching out into the future. A value of 100 at any point equates to earnings in that year being what they were at the start of 2020. We can then discount that stream back at (say) 5% which the DWS crew estimate as roughly the current equity cost of capital for non-financial firms. This gives us a Pre-covid baseline for an equity index value.
What we can then do is change two things.
Firstly, we can look at different economic scenarios. The V, the U, the L, swoosh etc. In each case we look at the next 5 years of earnings and show where they are for that year relative to the beginning of 2020. That is illustrated below, for a starting point I’ve taken the current consensus estimates for 2020 earnings (around 25% below previous expectations). In all cases the earnings return to 100% of the pre-covid expectations after 5 years other than the L-shape which returns to 90%.
We can look at the effect on the market level relative to pre-covid of changing the earnings cashflows but these amounts (keeping the discount rate constant.
What might be surprising here is how little changes. All that effort expended on debating an alphabet soup doesn’t amount to much! The v-shape recovery would see only a slight loss in present value – equivalent to an S&P 500 level around 3,100. The only scenario where there is any significant loss is the L-shape where I’ve said earnings settle permenantly at 90%. Even then it still points to an S&P 500 level of c 2,800.
Then we can play with the discount rate. Perhaps we think investors have become more fearful and demand a higher discount rate. Perhaps investors have taken their cue from gouvernement bond markets and reduced their discount rates. Perhaps they consider those two forces broadly offsetting and leave them unchanged. Results below.
The discount rate makes a big difference. If discount rates are 1% lower (don’t forget 10-year treasury rates are down about 1.2% since January, and many companies cost of debt capital is at all-time lows) then you can easily justify a stock market at new highs even with lower earnings for a few years. However if investors are applying a higher discount rate to account for fear, that’s when you’d expect much lower equity values – a fall of say 20 or 25%. A main conclusion of the DWS piece is that significant market falls are driven more by fear (who knew!) – as represented by a higher discount rate than they are by a realistic appraisal of a change in fundamental earnings which could only justify a much smaller fall.
It’s not exactly a revelation to say that markets are driven by fear of course, but we ought not to forget the role of the discount rate simply because it is much harder to get scientific about it than say, future earnings or CAPE ratios that we can go to town analysing a hundred different ways.
Look the reality is that markets being what they are, if most people think the rally is overdone then of course by definition it is. And if entire industries are permenantly damaged then equity values should be lower. But the discount rate lurks often unnoticed and does play a role. Remember no-one has the playbook for investing at zero nominal interest rates. With rates this low a significant part of equity values relates to earnings in 10, 20 or more years.
Narratives and counter-narratives play a massive role in how we all invest and make decisions more broadly. Often in investing it is enough to have just enough of a positive narrative to be able to get invested.
But hey, don’t forget, I was the one saying in March that the bear market could last a lot longer, so you know what to do 🙂
Check out my thoughts on how to invest when the rules change.
If you enjoyed this you might like my other pieces – the rise and rise of private markets.