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This year’s horrible market performance is Russia's fault, cries the media. Others put blame for recent stock declines at the feet of the Federal Reserve. Some fault Biden, the dollar, or OPEC. The financial media likes to have definitive explanations for every market gyration.
But few media professionals (Advisor Perspectives excepted) realize that a simple Finance 101 formula accounts for about 90% of recent stock market losses. On the other hand, maybe they just don't care. Biden, Russia, and OPEC garner many more viewers and advertising dollars than financial formulas.
This article explores the discounted cash flow model (DCF) and the discount rate embedded in stock valuations. The DCF model provides critical insight into how interest rates affect stock prices. Appreciating how the recent surge in yields impacted stock prices, we can focus on the future path of interest rates and earnings to formulate a clearer picture of where stock prices may be heading.
Finance 101
Whether buying shares of Apple or a stake in a local grocery store, you are sacrificing current capital in exchange for future cash flows. Accordingly, our job as investors is to calculate a fair price for said cash flows. First, we need to forecast the cash flows. Then we need to calculate their present value using an appropriate discounting factor.
The DCF model, a staple in entry-level finance classes, allows us to formulate a present value of future cash flows. The following example helps us appreciate the model.
Someone approaches you with an opportunity to buy a $55 cash flow occurring this year and another $55 next year. How much would you pay?
The DCF model calculates how much money today, growing at the discount rate, equals the future cash flows. In our example below, we use a 5% discount rate to find the present value of the $55 cash flows. The sum of the present values of the two cash flows equals $102.27. If we aim to earn 5%, a price of $102.27 for the two cash flows is fair.
Variability in discount rates
We can use the same formula to approximate how changing discount rates affect DCF valuations. Our example above was only two years. Valuing stocks entails much longer periods and with it, more variability based on changes to the discount rate.
From January 1, 2022, through October, the 10-year U.S. Treasury yield rose from 1.63% to 4.05%. Over the same period, the S&P 500 fell from 4,796 to 3,856. The graph below charts the S&P 500 and the running present value of a $100 cash flow expected 10 years from each date on the x-axis. The discount rate to formulate the blue line equals the appropriate 10-year Treasury yield plus a constant 5.5% risk premium. The graph shows that about 90% of the S&P 500 loss was attributable to higher interest rates.
Given that surging interest rates accounted for a good deal of the price decline, what impact did earnings changes have on the price?
Valuation contraction
S&P 500 earnings per share were 197.87 in the fourth quarter of 2021. Current expectations peg them at 190.91 at the end of the third quarter. The price-to-earnings multiple started the year at 24.09 and currently sits at 18.78. The multiple contracted by over five. How much of that contraction was due to earnings?
If we take the current EPS and solve for price assuming price to earnings didn't change this year, the result equals the S&P 500 price change related solely to the decline in EPS.
The slight $6.96 decline in EPS only accounts for about 3.5% of the 20+% change in the S&P 500.
A large majority of the market decline was due to interest rates, and a marginal percentage was because of earnings.
What's next?
Understanding how interest rates and earnings influenced stock prices this year, we can now consider how changes in the future will affect our expectations.
Let's start with earnings per share. Higher interest rates and the Fed's QT program will likely result in a recession and weaker earnings.
The graph below shows the Fed's favorite yield curve indicator of recessions, the 3-month/10-year yield curve, is negative. Typically, a recession doesn't start until the yield curve troughs and then turns positive. From the trough in the yield curve, which likely hasn't happened yet, to the start of a recession, it can take three months to over a year based on the prior four recessions.
How much may EPS decline if we enter a recession?
Since 1920 there have been 18 recessions. On average, EPS fell by 30.8% from its peak. The median decline was 20.5%, and the average of the last four was 53.7%.
The current P/E is close to the average of the last 10 years. Assuming the P/E doesn't decline further and conservatively assuming earnings fall by the median of 20.5%, we should expect another 20% decline in stock prices.
A more bearish scenario arises if we assume the P/E declines to 15 and earnings fall by 30.8%. In such a case, the S&P could dip to as low as 1,981. A worst-case scenario using single-digit P/E ratios and a 50+% drawdown in EPS would result in a dire outlook.
There is some good news to temper the bearish outlook. Interest rates will likely fall appreciably in a recession. A declining discount rate factor increases the present value of expected cash flows. If rates fall back to where they were at the start of the year, a positive 20% increase in share prices is expected.
There are bullish scenarios in which the economy remains stable and earnings flat. At the same time, inflation would normalize and interest rates would fall. Such a scenario likely means a bottom in stock prices is very near if it hasn't been reached already.
Summary
Value isn't measured by the extent that prices have declined, but by the relationship between prices and properly discounted cash flows. – John Hussman
Higher interest rates have taken a toll on stock prices. The rate increases will inevitably hamper economic activity and reduce inflation, ultimately resulting in lower discount rates. The bad news is that reduced economic activity will weigh on profits, which can easily counter the benefits of falling interest rates.
I have outlined the two most significant factors (interest rates and EPS) that explain forward returns. They may not be sexy rationales like Biden, OPEC, or Putin, but you should focus on them.
Michael Lebowitz has been involved in trading, portfolio construction, and risk management involving some of the largest and most active portfolios in the world. In addition to broad institutional experience, he also built a successful independent RIA allowing him to further extend his experience into the realm of investment management for individuals and family offices. Grounded in logic and common sense, he blends vast trading and investment expertise with economic viewpoints that delivers pragmatic and actionable thought leadership to clients.
Join our website today for a look behind the data at what is really going on with the markets and your money. www.realinvestmentadvice.com.
Contact him at [email protected].
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Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.
Given that surging interest rates accounted for a good deal of the price decline, what impact did earnings changes have on the price?
