Now that we are slightly over halfway through Q1 earnings season, it would be useful to see what we have learned, and how market expectations have developed through this pandemic period. Let’s begin with the big picture. FactSet reported that the bottom-up consensus forward 12-month estimate fell -1.9% last week, and -18.3% since downgrades began seven weeks ago. I have been monitoring the evolution of forward 12-month EPS for several years, and this level of revision is extraordinarily high. In the past, the magnitude of weekly revisions was usually about 0.1%, and swings of 0.2% would be considered high. Now, revisions are an order of magnitude higher at 1% or more. In addition, estimates have been falling while stock prices have been rising. Companies gave little in the way of
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Now that we are slightly over halfway through Q1 earnings season, it would be useful to see what we have learned, and how market expectations have developed through this pandemic period.
Let’s begin with the big picture. FactSet reported that the bottom-up consensus forward 12-month estimate fell -1.9% last week, and -18.3% since downgrades began seven weeks ago. I have been monitoring the evolution of forward 12-month EPS for several years, and this level of revision is extraordinarily high. In the past, the magnitude of weekly revisions was usually about 0.1%, and swings of 0.2% would be considered high. Now, revisions are an order of magnitude higher at 1% or more. In addition, estimates have been falling while stock prices have been rising.
Companies gave little in the way of earnings guidance during this earnings season. In fact, 47 companies withdrew their 2020 EPS guidance for the full year as management as uncertainty rose. However, there is a remedy for investors looking for greater clarity on the earnings outlook.
Top-down vs. bottom-up estimates
When the market experiences an unexpected shock, bottom-up earnings estimates are always slower to change. That’s because company analysts cannot quantify the shock to estimates without further discussions with management, and that process takes time. By contrast, top-down strategists can use economic models to estimate the effects of the shock on earnings, and top-down estimates are quicker to adjust.
We can see that in late 2017, when Congress passed a substantial corporate tax cut. Top-down strategists quickly coalesced around a one-time upward impact of 7-9% to earnings, while bottom-up company analysts were slower to react.
The same process is occurring today. Top-down S&P 500 estimates for 2020 is about 120-125, and about 150 for 2021. The bottom-up consensus is falling at different rates to converge to the top-down estimate. The bottom-up 2020 estimate of 133.83 is nearing the top-down range, but bottom-up estimates for 2021 are still far too optimistic compared to the top-down consensus.
Expect further bottom-up downgrades, but at a slower pace for 2020. How the 2021 estimates evolve will be of intense interest to investors, especially if they want to look over the valley of a dismal 2020.
What are companies saying?
EPS guidance is not the only way that corporate management communicates with the Street. Their primary tool of communication has been the earnings call, and their description of business conditions. The Transcript, which monitors earnings call, shows a severe decline, signs of stabilization at a low base, but an uncertain outlook for recovery.
It’s still tough to fathom the magnitude of the economic declines
“…we’re continuing to see record low passenger demand and revenue trends here in April and May, with operating revenue down roughly 90% to 95% year-over-year and single-digit load factors.” – Southwest Airlines (LUV) President Thomas Nealon
“…since the third week of March when we initiated widespread closures of stores in the U.S. we’ve seen the comps which include the impact of closures based on how we’ve defined comps for this period of time, it’s been fairly steady in the range of minus 60 to minus 70.” – Starbucks (SBUX) CFO Pat Grismer
“…in the United States, physician office visits across various areas of medicine are currently running down in the neighborhood of 70% versus pre-COVID-19 levels. – Merck (MRK) CFO Robert Davis
“We’re going to see economic data for the second quarter that’s worse than any data we’ve seen for the economy.” – US Federal Reserve Chair Jerome Powell
It’s different from the financial crisis. It’s more severe
“One is the early demand patterns, which we see coming out of the China market, some European markets clearly point toward the U-shape. And it’s very different from financial recession because the depth of the crisis is more severe than financial crisis” – Whirlpool (WHR) CEO Marc Bitzer
“…this is very different from ’08, ’09 for a bunch of reasons. I mean, first and foremost, it hit the entire economy, and it’s very dependent on the psychology of the consumer economic actors as to the rate and speed of the recovery.” – Lazard (LAZ) CEO Kenneth Jacobs
We are starting to see some leveling off of declines
“…you saw our decline of between 50% to 55% towards the end of the quarter in terms of volume in the last several weeks of March, and we’ve seen that kind of level off” – Laboratory Corporation of America (LH) CEO Adam Schechter
“…we’re seeing some early signs at this point that users are returning to more commercial behavior” – Alphabet (GOOG) CFO Ruth Porat
“It is too early to tell if this uptrend in the second-half of April is the start of a recovery…The reason it’s different in the last two weeks of April, is what we have seen is that as some of these stimulus payments have come through, people are prioritizing pent-up demand in areas like automotive, like home improvement, and they’re not spending it on lower ticket categories, like entertainment and restaurants.” – Visa (V) CEO Vasant Prabhu
“…we’re starting to see a little bit of that stabilization impact come through, for example, in markets like Italy, Germany, Poland, Australia – Austria.” – Mastercard (MA) CFO Sachin Mehra
“…we’ve seen a strong improvement in comparable sales over the course of the month of April.” – Restaurant Brands International (QSR) CEO Jose Cil
“We are already seeing green shoots suggesting that economies and industries around the world are either rebooting or preparing to reboot in the coming weeks.” – Stanley Black and Decker (SWK) President & CEO James M. Loree
“The high-yield bond market has begun to reopen, especially at the higher end of the speculative grade rating scale” – Moody’s (MCO) President & CEO Raymond W. McDaniel, Jr.
However, our desire for normalcy may be outpacing reality. This may be the rare time that we don’t get a V shaped recovery.
“I remain very concerned that this health emergency and therefore the economic fallout will last longer than people are currently anticipating. And while there are massive societal costs from the current shelter-in-place restrictions, I worry the reopening in certain places to quickly before infection rates have been reduced to very minimal levels, will almost guarantee future outbreaks and worse, longer-term health and economic outcomes.” – Facebook (FB) CEO Mark Zuckerberg
“…realistically, we just can’t expect that things are going to be back to normal in 6 or 12 months. I don’t believe that for a minute.” – Southwest Airlines (LUV) Chairman & CEO Gary Kelly
“…what I would exclude right now, I would say, very low probability, the V-shaped recovery.” – Whirlpool (WHR) CEO Marc Bitzer
The Berkshire Hathaway virtual shareholder meeting on the weekend was also instructive for investors. Here are some important takeaways from that meeting:
- Berkshire made new sales in its equity portfolio and cash and equivalents rose to $137.3 billion, up from $128.0 billion three months ago.
- When asked why he hasn’t bought anything, in the manner of buying preferred shares of distressed companies at the bottom of the GFC, Buffett replied, “We have not done anything because we haven’t seen anything that attractive,” (Translation: Nothing is cheap.)
- Berkshire sold its entire position in airline stocks. Buffett: “When we bought [airlines], we were getting an attractive amount for our money when investing across the airlines…I don’t know that 3-4 years from now people will fly as many passenger miles as they did last year …. you’ve got too many planes.” (Good luck to Boeing, Airbus, and the entire airline industry.)
- On underlying business conditions: Some of the losses in sales are permanent, such as See’s Candy’s Easter inventory, some already-weak businesses are not coming back, and not all job losses will be recovered.
While Buffett was always upbeat about the long-term outlook and warned not to bet against America, this was a sobering outlook from a legendary investor known as the Oracle of Omaha.
FactSet also reported that, as of last Thursday, the S&P 500 was trading at a forward bottom-up derived P/E of 20.3, which is well ahead of its 5-year average of 16.7 and 10-year average of 15.0. As a reminder, forward 12-month EPS is falling, so forward P/E should rise even if stock prices remain steady. Moreover, valuations were already stretched even before the onset of the COVID-19 pandemic.
From a long-term historical viewpoint, the forward P/E of 20.3 was last exceeded when the market deflated from the Tech Bubble of the late 1990’s.
These extraordinary levels of valuation brings to mind the warnings from the Rule of 20, which flashes a sell signal whenever the sum of the forward P/E and inflation rate exceeds 20. Even if we were to assume no inflation, the Rule of 20 warning would be triggered by the P/E component alone. As CPI inflation is backward looking, we substituted the 5×5 inflation expectations from the bond market of 1.4%, and arrived at a Rule of 20 reading of 21.7.
What about the Fed, and low rates? Doesn’t that justify a higher P/E ratio? Aswath Damodaran at the Stern School at NYU calculated an equity risk premium, and a COVID ERP based on a 30% drop in 2020 earnings, and a 75% recovery by 2025 (h/t Callum Thomas). The COVID ERP is not very different from the levels when the crisis began, and equity valuations were already stretched then.
In conclusion, the increasing level of bifurcation between stock prices and earnings estimates is raising valuation risk for the equity market. Forward P/E ratios are already at the levels last seen when the Tech Bubble burst, and long-term valuation techniques like the Rule of 20 and ERP also point to heightened downside risk based on pure valuation approaches. As well, there is little signs of fundamental momentum. Comments from management during Q1 earnings season has been downbeat, and the level of uncertainty is high.
Long-term investors should take note, and assume a position of maximum defensiveness.