My Comments: There is mounting pressure to start ignoring the negatives associated with the pandemic and instead focus on economic recovery. I understand that. The big question is where on the spectrum that runs from saving everyone to letting people die should we fall?
This week I’m going to focus my thoughts on the stock and bond market. That’s because so many people in charge who are not MDs, believe market performance is the ultimate goal of society. Some prominent MDs seem willing to compromise their values so long as those dying are not their personal patients.
I know I’ll get pushback because despite my 45 years as a practicing financial professional, many people on the right think I’m full of s**t. How dare I contradict their belief that God has blessed us with clairvoyant leaders? Frankly, I don’t care what they think.
Once again, the price you see posted for stocks and bonds is driven by supply vs demand. Demand is driven by expected earnings going forward. If the price moves up or down, it’s a result of either dwindling demand or excess supply. A good example today is the price of oil; too much supply in response to demand dropping as a result of the global pandemic.
Meanwhile, many millions of Americans are increasingly worried their savings are at risk. Regardless of hopes and prayers, they fear their financial future is increasingly uncertain. I have no certainty either, just a faith that a new normal will eventually emerge from all this. My hope and prayer is that I’ll still be alive to participate.
(Please note: As of today at 9:12 am, the S&P was valued at 2,874)
Stock analyst’s discounted cash flow model calculation pegs S&P500 fair value at 1,800
by Mark Hulbert \ 13 APR 2020 \ https://tinyurl.com/ydackjvk
Has the U.S. stock market stopped discounting the long term? It certainly appears that way, since during the coronavirus pandemic the market has become hyper-focused on the extremely short term. Stocks will plunge or soar on the slightest daily steepening or flattening in the coronavirus infection’s curve, for example.
It seems hard to square that behavior with the notion that the stock market discounts changes that are coming down the pike that are still years away. After all, no one doubts that eventually we will recover from the coronavirus and the U.S. economy will return to some sense of normalcy. Why, then, does the stock market trade 20% below where it stood in February?
The answer boils down to one word: Uncertainty. Increases in uncertainty have a surprisingly toxic effect on the stock market’s fair value.
The market’s reaction is not necessarily irrational, in other words, even if we assume the market was fairly valued at its February high.
To explain why, consider the discounted cash flow (DCF) model, which is widely used to assess the potential worth of not just stocks but any asset. DCF calculates the present value of future cash flows the asset produces. The key variable in the model is the discount rate — the amount by which we discount amounts that may be earned in the future. The higher the discount rate, the less that future cash flows are worth today.
To illustrate the huge impact of a higher rate, consider what the S&P 500’s SPX, +2.67% fair value would be under several discount rate assumptions. The calculations, which are summarized in the table below, were conducted by Vincent Deluard, head of global macro strategy at INTL FCStone.
(To be sure, Deluard had to make a number of other assumptions as well. But playing around with those assumptions turned out to have far less impact on the S&P 500’s value than changing the discount rate. For the record, Deluard assumed that corporate revenues in the first quarter of 2020 will be 25% lower than their year-ago 2019 level and 50% lower in the second quarter. He then assumed that revenues would start to recover and, by the end of 2021, would be back to their pre-COVID-19 trend. He also assumed that the 10-year Treasury yield TMUBMUSD10Y, 0.625% would be steady at 0.8%, which is close to where it stands today.)
|9.8% (long-term average)||1,851|
|6.2%||3,386 (Feb. 19 high)|
Here’s how to read Deluard’s results: Given his assumptions, the S&P 500 would have been fairly valued at its Feb. 19 high if we assume a discount rate of 6.2%. If we instead assume a discount rate that is equal to the long-term average, then the S&P 500’s fair value falls to 1,851 — 45% lower than its Feb. 19 high.
The discussion up until this point leads us to the crucial question: How much has the stock market’s discount rate grown since the coronavirus outbreak?
Deluard says that the bond market has already answered the question: The spread between investment grade bond yields and the risk-free rate has increased by between 1.5 and 2 percentage points, while high-yield bond spreads have risen by between 5 and 7 percentage points. The average of these is 3.8 percentage points, and if we add that average to the implied rate at the Feb. 19 high, we get a discount rate of 10.0%.
That translates to an S&P 500 fair value of 1,800.