Trying to forecast the low of equity markets in the current environment is like being a blindfolded tightrope walker seeking the wire with his front foot. A miss could be rather unfortunate. This post takes you through my “educated guess work” seeking a solid enough bottom. Spoiler: keep a lifeline handy.

The likely scenario looking forward is for a world recession until a vaccine or cure are found and made widely available. In the best case, this would happen within 6 months (a cure based on an existing medicine) and in the worst case sometimes in 2021 with a vaccine and/or a novel cure.

In the meantime, the extraordinary global “whatever it takes” monetary and fiscal stimulus will help keep economies running at minimal speed, hopefully preventing a depression.

Eventually, the virus will be conquered and the world will restart. The most likely scenario at that point should be one of a long recovery period to close the large accumulated output gaps without much risk of excessive inflation developing given the accumulated debt and labor slack, and thus very accommodating monetary policies for a long period. Barring another black swan, we could be living another extended economic and financial cycle.

Before we get there, however, fundamentals and sentiment will seriously deteriorate along with labor markets, corporate profits, investments, and widespread credit defaults.

The challenge for equity investors is to find a re-entry point sufficiently comfortable from a valuation and confidence standpoint to be invested when equities start rising again, because they will.

But, much like at peaks, troughs in profits, sentiment and valuations rarely coincide. Can the Rule of 20 help us build our equity positions in a timely and sensible way? It did in 2009. It also warned us early and repeatedly enough near the recent peak. Not that it helps forecast and time recessions, recoveries and any kind of swans but it clearly helps to objectively measure and appreciate risk vs reward, allowing investors to tune their equity exposure based on an historically dependable valuation tool.

The Rule of 20 simply says that the Rule of 20 P/E invariably cycles between 16 and 24 with Fair Value at 20. Below 20, equity markets are increasingly attractively valued. Vice versa above 20. At the 20 Fair Value, the valuation upside from 20 to 24 (+20%) equals the valuation downside from 20 to 16 (-20%). Natural fear and greed phenomena occasionally result in some temporary slippage outside of the 16-24 valuation band.

People relying on the conventional P/E run much more risk of whipsaws outside the historical 15-20 band.

Incorporating inflation in the valuation (really a proxy for interest rates), the Rule of 20 P/E displays a much more consistent valuation range. Regardless of economic or financial environments, the R20 P/E invariably cycles between 16 and 24.

The charts below plot the Rule of 20 P/E (P/E plus inflation), the conventional P/E and trailing EPS around various bear markets (within the black rectangles) during the past 60 years.

THE 1961-1962 PAPA BEAR (-23%)

A recession from Q2’60 to Q1’61. Small decline (-3.5%) in profits until December 1960, then a 7.3% slide to June 1961. But the bear market only began in December 1961, crashing 23% through June 1962 while profits were strongly recovering. This was a valuation bear market after the Fed tightened during the second half of 1961 when inflation was accelerating. Equities bottomed when valuations neared the low of the R20 P/E range (17.4) with rising profits and receding inflation.

THE 1966 BABY BEAR (-18%)

“Fairly valued” equities declined even though profits rose strongly. The Fed tightened starting in December 1965 through October 1966, when the R20 P/E reached 17.0 in September 1966.

THE 1972-1974 MAMA BEAR (-46%)

A nasty Big Mama bear that began in December 1972 at excessive valuations with the Fed busy reigning in a booming economy. After a 10% correction through August 1973, valuations reached attractive levels thanks to still rising profits (they peaked right at the market trough in September 1974). But equities tanked 42% after OPEC declared an oil embargo in October 1973 that eventually quadrupled oil prices, upending the world and sparking an inflationary spiral and an immediate recession.

The Fed made things worse, tightening again between March and June 1974 to fight the sharply rising inflation. Fed funds rates peaked in early July at 13.3% before dropping to 5% in early 1975 when the recession ended.

Equity markets troughed in September 1974, four months before the recession ended, at a remarkably low 7.2 conventional P/E but a consistent R20 P/E of 17.4 (inflation was 10.2%). Equities rose strongly even against sharply declining profits (-15% through September 1975) during a recession that ended in February 1975. Inflation peaked during Q1’75 and dropped almost 50% during the next 12 months.

THE 1980-1982 PAPA BEAR (-23%)

A Papa bear during 2 back-to-back recessions that ended in October 1982. There were also 2 back-to-back Fed tightenings, one in Q1’80 and another one in Q2’81. Profits were flattish until December 1981, then declined 16% but equities bottomed in July 1982, 5 months before the profits low when the R20 P/E was 15.1 (conventional P/E: 7.5).  Between July 1982 and August 1983, inflation dropped from 7.7% to 3.0%.

THE 1990 BABY BEAR (-14%)

The Fed tightened seriously between March 1988 until May 1989. A mild recession began in June 1989 but a real estate/financial crisis spooked investors for most of 1990. Equities troughed in October 1990 at a R20 P/E of 18.4, even though profits tumbled another 17% during the following 13 months.

THE 2000-2002 MAMA BEAR (-46%)

A 2-year Big Mama bear starting 7 months before the recession that cut profits by 32% in 15 months. The Fed tightened throughout 2000. The recession began in March 2001 and ended in November 2001 but the still wildly overvalued stocks lost another 28% during the following 10 months. Equities bottomed in September 2002 after profits started to recover but at valuation levels that were historically high for a market low. In fact, equity valuations remained very high until 2005 as profits rose steadily while inflation remained very subdued.

THE 2007-2009 MAMA BEAR (-56%)

This other Big Mama Bear started in July 2007 and marked the end of a significant 3-year Fed tightening policy. Mama bear stayed put for 20 months until March 2009, accompanied by an 18-month recession/financial crisis that ended in May 2009 after decimating corporate operating profits, from $91 in mid-2007 to …varying levels depending on who you listen to but ranging from $40 to $61, the latter number being “normalized”, i.e. an estimate of what earnings would have been excluding some extraordinary write-downs and write-offs emanating from the extraordinary financial crisis. GAAP profits were almost completely eradicated in 2008 and 2009. Many investors got too focused on GAAP profits and totally missed a large part of the bull market.

Some key observations from the above:

• During the 5 recessionary down markets, the low point for equity markets was reached 3 to 5 months prior to the end of the recession in 4 of the 5 episodes. In 2001-02, equities turned up one year after the recession ended.
• Equity market troughs happen irrespective of profit trends around the lows. In 4 of the 7 episodes reviewed, but in 4 of the last 5, equities troughed and rose while profits were still declining, sometimes brutally like in 1974-75 and 1990-91.
• Fed tightening was present before/during every bear market.
• Excluding the 2000-02 episode, market lows were reached at a Rule of 20 P/E between 14.5 and 18.4 (average of 16.7, median of 17.2) and a conventional P/E between 7.2 and 16.1 (average of 11.8, median of 12.8). The range of valuation lows was much narrower using the R20 P/E. (All P/Es on trailing EPS).

Now, let’s consider the Rule of 20 Fair Value which has a 98% correlation with the S&P 500 and which we know will be impacted by 2 conflicting trends in the coming 6-12 months (profits down, inflation down). The R20 Fair Value [trailing EPS x (20 – inflation)] simply calculates what the S&P 500 Index level would be if trading at its neutral, fair, valuation level of 20 where the valuation upside equals valuation downside. Fair Value declines along with lower profits but rises with declining inflation.

In effect, the Fair Value approach adds the profit dynamics to the valuation measures provided by the R20 P/E.

THE 1961-1962 PAPA BEAR (-23%)

The R20 P/E rose while Fair Value declined and then declined while Fair Value rose. The bear market ended at 17.4 R20 P/E and rising FV.

THE 1966 BABY BEAR (-18%)

Valuation declined along with FV. The bear market ended at a R20 P/E of 17.0. FV stabilized as slowing inflation offset a continued slight erosion in profits.

THE 1972-1974 MAMA BEAR (-46%)

The Mama bear ended at a R20 P/E of 17.4 even though FV only bottomed 5 months later. Note that the R20 P/E was near 17.0 for almost a year before the market low. The apparent cause is that inflation was strongly accelerating and the Fed tightening along the way. The bear ended shortly after the Fed started to ease.

THE 1980-1982 PAPA BEAR (-23%)

The bear ended at a very low R20 P/E of 15.1 in July 1982. Fair Value had been rising for a while (+37% in the previous 12 months) as rapidly declining inflation more than offset sluggish profits. The U.S. had suffered a double-dip under Volcker’s harsh medicine (Fed funds at 20% in mid-1981). Buying early at a R20 P/E of 17 in January 1982 would have cost you 10% for 6 months but made you 20% over 12 months, and the rest is history.

THE 1990 BABY BEAR (-14%)

The bear ended at a R20 P/E of 18.4 in October 1990, right in the middle of a 24%, 3-year drop in Fair Value. Equity valuations had been very cheap ever since after the October 1987 crash that culminated a 43% meteoric rise in the S&P 500 Index during the preceding 12 months. Strangely, investors quickly bid equities up well beyond FV until 1994.

THE 2000-2002 MAMA BEAR (-46%)

The Mama bear ended in September 2002, well past the November 2001 recession end, at a R20 P/E of 21.5 on rising FV buoyed by rising profits and sharply slowing inflation as well as a highly accommodative Fed. Equities rose in spite of very high valuations that endured until 2005.

THE 2007-2009 MAMA BEAR (-56%)

This brutal and extended Mama bear ended in March 2009 at a R20 P/E of 12.1 (the March 6 absolute low of 666), a level last seen in 1955. The low was reached after Fair Value had stabilized during the previous 3 months. Profits were still weakening (another –7%) but inflation was declining, from 2.5% in August 2008 to 1.8% at the March low on its way to 0.6% in October 2010.

In all, bear markets end irrespectively of the trend in Fair Value. At the market trough, Fair Value was rising 3 times, flat twice and declining, strongly, in 2 episodes.

A rising Fair Value is a welcomed backwind for a ship powered by sputtering engines amid an unsteady sea: it strengthens confidence and boosts the probabilities of shortly getting through the turmoil. Rising profits improve corporate fundamentals while easing inflation generally deflates interest rates (discount factor), keeps costs under control and fosters easy monetary policies.

Conversely, a declining Fair Value increases uncertainty and risks. Declining profits damage corporate fundamentals while rising inflation tends to stiffen monetary policies, often to the point of generating a recession and a bear market.

And yet, equity markets have shown that they can stop declining and turn around even when Fair Value is going sideways at low levels or even trending lower like in 1966, 1974 (Mama), 1990 and 2009 (Mama). In 4 of the last 7 bear markets, equity markets troughed before fundamental conditions improved. Briefly said, valuation (particularly the Rule of 20) matters more than fundamentals.

RECAP:

• Equity markets trough irrespective of trends in profits and Fair Value.
• Excluding the 1990 and 2000-02 bears, the other 5 market lows reviewed occurred at a Rule of 20 P/E between 14.5 and 17.4 (average of 16.3, median of 17.0). The 1990-91 and 2001 recessions were both very short and shallow with relatively less hawkish prior monetary policies.
• These valuation lows were measured on trailing earnings and inflation. They have endured even after profits and/or Fair Value subsequently declined. In effect, rising valuations more than offset deteriorating fundamentals once investor confidence returned.
• Every low was preceded by a dovish Fed (4 lows occurred right around the first move) but the last 2 lows occurred well after the first easing).
• Fed tightening is generally unfriendly to equities even at low valuation levels. Avoid fighting the Fed!

To sum it all up, bear markets end when fear is sufficiently embedded in valuations and the Fed has become friendly. The Rule of 20 provides a dependable reading of equity valuations. During the last 7 bear markets, accumulating equities when the R20 P/E was below 17.5 AND the Fed was clearly in easing mode has proven rewarding.

THE 1957-58 ASIAN FLU PANDEMIC

In February 1957, a new influenza A (H2N2) virus emerged in the Guizhou Province of southwestern China, triggering a pandemic. By midsummer it had reached the United States, where it appeared to have initially infected relatively few people. Several months later, after the school year resumed, a second, particularly devastating wave of illness struck. 

Thanks to Dr. Maurice Hilleman, chief of respiratory diseases at the Walter Reed Army Institute of Research in Washington, D.C., who convinced companies to begin working on flu vaccines in the spring of 1957, the country was ready with a vaccine when the new flu strain hit in September. Still, the virus killed an estimated 70,000 Americans and one to four million people worldwide, but experts suggest it would have killed many more if not for the vaccine.

The Fed was in serious tightening mode from mid-1955 to the fall of 1957 as the U.S. was coming out of a slight deflationary period and prices accelerated through the spring of 1957 to +3.7%. The Fed last hiked rates by 50 bps in August to 3.5%, cut them 50 bps in mid-November, 25 bps in January and brought them down to 0.50% in February 1958, just before the recession ended in March.

We don’t know what were the respective contributions from the Fed’s actions and the pandemic but U.S. GDP cratered at annual rates of -4.1% in Q4’57 and -10.4% in Q1’58, the worst quarterly drop since WWII (Q4’08 was –8.9%). It was also, at 8 months, one of the shortest U.S. recessions ever.

The Baby Bear (–18%) troughed at a R20 P/E of 14.5 with stable inflation and the Fed in easing mode. The R20 FV kept declining for another 9 months along with earnings.

THE 2020 POLE BEAR

This bear came down the fire pole in a hurry. In one month or so, it slid as much as what the average bear typically does in 12 months as LPL Research shows.

World economies and equity markets are all coming down on a fire pole, all fighting the same scary blaze, in total economic and financial darkness. For investors, using trailing data makes no sense in this environment. But forward data is as bleak as it is unpredictable.

BEAR BOTTOM

In early 2009, the world financial system was totally upside down and huge GAAP and non-GAAP losses were recorded in Q4’08 and the first half of 2009. Trying to figure out S&P 500 earnings bottom up in this environment was an impossible, and rather futile task.

I then elected to attempt to “normalize” corporate profits using top-down data. The idea being that corporate America has an embedded minimum level of profitability that should normally provide a fundamental floor to equity  markets. On March 2, 2009, I posted S&P 500 Valuation Analysis: Near Bottom followed the next day by the complete analysis S&P 500 P/E Ratio at Troughs: A Detailed Analysis of the Past 80 Years (sorry, charts have disappeared ).

Contrary to 2009, we do not want to imagine the absolute worst case here… but let’s try a very bad case.

If we assume a 6-month recession and that S&P 500 revenues tumble 8% (-16% in 2008-09 during an 18-m recession, –6.8% in 2002- 6-m recession), and that net margins decline from 11% to 7.5%, a 32% correction (–55% in 2008-09 GFC, -30% in 2002), EPS would drop 40% to about $100.

Let’s now value the S&P 500 using a “low on low P/E”, that is the index bear market low divided by the eventual cycle low EPS. At a 2009 R20 low/low P/E of 18.5 = 1850.

Using the relatively more stable book value and ROE relationship, during the GFC the S&P 500 book value declined 8.0%, more than twice the 2001-02 hit (-3.0%) because of all the financial write-downs and write-offs and some large bankruptcies, and its ROE crumbled from 17.6% to 11.1%. These are unlikely to decline as much this time given the wide monetary and fiscal backstops quickly erected but let’s assume a 5% drop in BV to $900 and a 13.0% ROE, the average low ROEs of the last 4 cycles adjusted for the current lower tax rate.

(Data from CPMS/Morningstar)

That’s an EPS low of $117; with a R20 P/E of 15.4 = 1800; at 18.5 = 2150. Remember that the 15.4 low R20 P/E was in 1982 when interest rates were in the stratosphere: T-bills at 11.5% and 10Yr Treasuries at 14%.

A last measure is price to book value. The low in 2002 was at 2.42x BV and in 2009 it was at 1.56x BV. At the low $900 BV derived above, we get 1400 to 2200, quite a wide range. But our assumed 13% ROE is 20% higher than in 2009 (11%) and equal to 2002, and is much less debt levered than in 2008-09 (D/E of 1.3 vs 0.8 in 2002, current = 0.9) justifying a P/B closer to the 2002 level.

Recap on this “worst” case, top-down exercise:

• R20 P/E 2009 low on $100 EPS: 1850
• R20 P/E 2009 low on $117 EPS: 2150
• Low P/BV on BV low: 2200

BEAR WITH ME

As shown, historically, bear markets have bottomed at a R20 P/E ranging between 14.5 and 17.4 (average of 16.3, median of 17.0) trailing earnings, with a friendly Fed, and valuation lows held, irrespective of trends in profits and Fair Value.

At its current level of 2500 and $164.59 trailing EPS, the S&P 500 Index is at 17.5 on the R20 P/E scale. It would need to decline to 2000 to reach the 14.5 range low, really just about as low as it got historically barring depression/deflation. At the 16.3 average: 2300.

My top down approach finds a 1850-2200 low range using “possible” cycle lows in book values and ROEs to derive “possible” cycle lows in earnings to which we applied the Financial Crisis valuation low of March 2009 using that cycle’s lowest earnings of $40 (-55% from peak). That’s like saying “what’s the lowest multiple investors would use assuming they knew the actual low profits in this cycle”. At 1850, we would get the lowest multiple on the worst probable profits.

FYI, Goldman Sachs is now seeing $110 for S&P 500 EPS this year, bouncing back to $170 in 2021.

I would not bet much on that $170 number, wishful thinking like if nothing had happened. Consider that

• we don’t know how and when this virus outbreak will end;
• everybody has been terribly scared and bruised; individuals and businesses will change their behavior, perhaps significantly: consume less, save more;
• retirees and near-retirees will have been particularly impacted in their income, savings and pension funds; they will save even more;
• governments at all levels will also be bruised, they will need revenues to restore their finances and to spend on various health issues; priorities will change and so will taxation.

NOTHING WRONG BEING LATE

Risk tolerance varies a lot, even more so in the current situation where the worst case is really bad. As Richard Bernstein Advisors explain, being late is no great sin:

The table below shows the returns for the full 18-month period encompassing the six months before and the 12-months after the market bottom. We compare the hypothetical returns of an investor who owns 100% stocks for the entire period (“6 months early”) with one who holds 100% cash until six months after the market bottom (“6 months late”).

In general, it has been better to be late than early. Not only do returns tend to be greater when you invest “late,” but more importantly, you’ve never had negative returns in this strategy. When investing “too early,” the magnitude of the drawdowns at the bottom often more than offsets the initial rally off the bottom (nearly a third of the time).

I looked at valuation levels 6 months early and 6 months late for each case since 1957 except 1987 (2-month crash, irrelevant). An investor disciplined to only buy when the R20 P/E is below 20.0, i.e. below Fair Value, would not have bought early in 5 of the 6 bear markets it was better to buy late and would have been successful buying early at attractive valuations in the other 3. The only miss would have been 1974 (-4%) but there would have been a huge win in 1982 (46%).

Conclusion: ok to be early if equities are cheap enough, but still nothing wrong being late if your risk (stress) tolerance requires.

ANOTHER WORST CASE!

Unfortunately, this is far from a normal downturn, a normal recession, a normal bear. So the following is not a far-fetched dismissible scenario. Demand and supply have been destroyed around the world and they will not (cannot) return V-shaped. A deep/long crisis could well hit income and savings so much that a new “new normal” would occur around the world, even potentially causing depression/deflation.

It happened between 1930 and 1933 (–10.7% deflation in 1932), dragging the R20 P/E down near zero along with an 80% crash in the R20 Fair Value as earnings collapsed 75% over 3 years.

Equities did not really recover until Fair Value turned up in early 1934, FOUR years later!

Nothing wrong being late…

The Rule of 20 P/E is currently 17.5, normally the high re-entry level, yet not a clear bargain, particularly given all remaining risks and fuzzy future prospects.

Most investors will want confidence

• that the coronavirus is being controlled with limited risk of a deadly seasonal return in the fall; a cure by summer would secure everybody before a vaccine ends the pandemic: odds are good on that score.
• that the fiscal and monetary measures are effectively preventing a depression: also good odds given the widespread “whatever it takes – we’ll deal with whatever consequences later” policies.
• that our leaders actually lead sensibly and intelligently with coordinated strategies: hmmm…efficient and sensible leadership varies a lot by country, even by state…Some decisions could have dire consequences.

Beyond the bear, it is reasonable to assume that valuations will not quickly return to recent excesses. Previous Mama bears left enough bruises to keep people cautious for a while as these charts illustrate:

The first chart covers 1980 to mid-1991. From the low in September 1982 to the next peak in 1987, the R20 P/E (black line) needed 40 months to return to its 20 Fair Value level, spending the first 36 months deep into undervalued territory. A similar cautious state prevailed after the October 1987 crash as the R20 P/E returned to 20 only 31 months after the sudden and quick bear punch.

The next chart covers the last 2 Mama bears. After the 2000-02 wallop, valuations spent the better part of the next upcycle in the 18-20 R20 P/E range. Actually, it was not until well after the 2008-09 brutal and enduring Mama bear that valuations successfully crossed into the rising risk area in mid-2016.

Given this nasty Pole bear and its viral origins, it seems reasonable to expect another extended display of investor cautiousness. If so, it would be more appropriate to think of the equity valuation range for the next 2-3 years as between 16 and 20. There is really nothing wrong with that. It means that Mama bear will eventually morph into a gentle, slowly aging bull wary of jumping wildly across the Fair Value fence where it always transforms itself into the dangerous ursid kind. Bulls can also be prudent and calm.

Some of Bob Farrell’s ten rules should be recalled here:

• 5. The public buys the most at the top and the least at the bottom
• 6. Fear and greed are stronger than long-term resolve
• 8. Bear markets have three stages — sharp down, reflexive rebound and a drawn-out fundamental downtrend

It is generally during the drawn-out fundamental leg that capitulation occurs, when people get really scared and discouraged by the relentless negative data and bearish media coverage. We shall see if the eventual victory on the virus can totally offset the terrible economic, financial and corporate data of the next several months.

Our politicians are not seasoned confidence builders, to say the least. With a U.S. presidential election only 7 months away, and so much at stake, it is fair to expect additional volatility also stemming from that wild bullpen.

Bob’s rule #10:

• 10. Bull markets are more fun than bear markets

Related posts:

• March 16: PANDEMONIUM
• March 10: BOTTOM FISHING?