Fair Value Model 2Q20
Gina Martin Adams & Michael Casper

(Bloomberg Intelligence) — The S&P 500 could stretch to 3,300 to price in a recovery half as strong as average beginning in 2H, according to our scenario analysis, but it will take EPS growth closer to average to return the index to former peaks. Analysts forecast a well-below average EPS rebound, with S&P 500 gains to 3,200 over the next year. (05/07/20)

1. Fair-Value Model: Wobbly Climb May Go On
Valuation Model Hinges on Rates
Source: Bloomberg Intelligence
Unsteady prospects for recovery and the 2020 election may weigh on risk tolerance in the near term, but our macro-derived model for S&P 500 valuations suggests Federal Reserve support will likely remain more than enough to support a rebound in equity valuations. Our base-case scenario, which uses short-term interest rates remaining extremely low, the yield curve widening slightly to 65 bps, credit spreads staying wide and earnings inching higher, suggests stocks are fairly valued at 21.9x earnings. Currently, the index is trading on 21.8x 2020 and 17.5x 2021 earnings estimates.

Equity-market valuations should stay a bit high against a backdrop of lower-for-longer interest rates, as long as the virus doesn’t accelerate again, taking down forward earnings forecasts even more. (05/07/20)

2. Modest Recovery on Low Rates Fuels Positive Bias
BI’s S&P 500 Scenarios: Pricing 2021 Recovery?
Source: Bloomberg Intelligence
S&P 500 gains may be a bit above those implied by the aggregated bottom-up consensus, according to our baseline scenarios, though it doesn’t appear stocks are likely to retest 2020 highs anytime soon. Analysts forecast 3.5% recovery in EPS beginning in 2H, and a multiple of 20.4x for the index, landing at an aggregated S&P 500 target of just under 3,200. If we assume a recovery half as strong as average in the first year after recession, or 5% EPS growth off the 2Q low, our baseline scenario implies stocks could get closer to 3,300.

In a bear case, where the recession is extended and earnings tumble another 10%, stocks could sink to 2,640. In a bull case, however, where EPS growth matches long-term average growth of 10% in the first year of recovery, stocks could close in on 3,680. (05/07/20)

3. Range of Experience Is Vast in First Year of Recovery
Earnings Growth History
Source: Bloomberg Intelligence
The historical range of EPS downturns and recoveries has been quite wide, but the average one-year rebound following EPS lows is 10%. An analysis of the troughs in EPS levels since 1959 reveals that in the year leading into the low point, EPS contracted by a median 14.6%; it stretched from no decline in 1998 to the 35.8% drop in the Great Financial Crisis. Recoveries were similarly varied, posting a median 10.1% EPS expansion but varying from 0.8% associated with the 1970 earnings recession to a 26.5% gain following one in 1975.

The Covid-19-fueled earnings recession will likely be unique: Bigger declines usually are followed by larger recoveries, but that’s not expected this time. (05/07/20)

4. Policy Support Quite Meaningful for Stocks
Valuations, Earnings Growth and S&P 500 Price
Source: Bloomberg Intelligence
Extremely accommodative monetary policy and its effect on interest rates and credit spreads should effectively elevate valuations, keeping equity prices from testing former lows, even if economic progress is extremely sluggish. If our valuation model is correct — and very low interest rates but improving prospects for a modest recovery imply a fair multiple for S&P 500 stocks is almost 22x — then current market prices imply an expectation that earnings will fall by almost an additional 10% after 2Q. This seems unlikely as long as economic reopenings occur over the next few months, but it’s certainly not beyond the realm of possibility if reopenings can’t be sustained. (05/07/20)
5. S&P Multiples Extreme But Supported by Low Rates
S&P 500 Forward PE Ratio BF 12-Month
Source: Bloomberg Intelligence
At first glance, S&P 500 forward price/earnings multiples look extreme, but low interest rates that are likely to persist long into the future may suggest rumors of a dearth of valuation opportunities are overblown. The index’s forward PE is 20.2x, more than 1.4 standard deviations above the average since 1990. However, the 10-year Treasury is a mere 12 bps above all-time lows. Analyst expectations for full-year 2020 EPS are at minus 20.1%, and forecasts for recovery beginning in 3Q imply one of the slowest EPS rebounds on record.

The Covid-19 earnings recession figures to be unique for both speed and depth, potentially disrupting the market multiple severely. Nonetheless, if rates remain low and credit spreads continue to tighten, the multiple will likely remain high. (05/07/20)