This post was published on March 18, 2021 when the stock market was falling apart. My goal was to help people feel more calm by going through a logical analysis of predicting when the bleeding would stop. I also provide an update on what my views are on stocks at the end of this post.
Are you wondering when the stock market will bottom? So am I!
When there is stock market pandemonium, there tend to be a lot of worst-case scenarios thrown around e.g. zombie apocalypse with no food, electricity, or running water. Because of the hysteria, the stock market tends to both overshoot on the upside and on the downside.
As rational investors, we acknowledge that nobody can with certitude predict a stock market bottom. However, it’s worthwhile to at least think about various entry points to put additional capital to work if you are a long-term investor.
As long as we have excess cash flow, we can either hoard cash or make an investment. I tend to consistently do the latter since my cash allocation is generally at capacity.
To be able to predict the next stock market bottom, we must first look at history. For example, from history, we know that the average bear market lasts about 17 months and corrects about 35% from the peak (2,200 on the S&P 500 if so). Therefore, although no two bear markets are exactly alike, we can reasonably assume the next or current bear market will do something similar.
The second thing we need to do is understand valuation. The S&P 500 has an annual earnings number and a P/E ratio. The P/E ratio moves up and down depending on the stage of the market. When there is euphoria about earnings growth, valuations (P/E and other ratios) tend to go up. When there is massive pessimism, valuations tend to go down.
Using the current P/E ratio as an example, when the S&P 500 was at 2,530, its P/E was at 19. With the historical median P/E at 15X, we could see the S&P 500 at 2,000 if we revert to the median.
Finally, we can make educated estimates on quarterly earnings percentage declines in a bear market to guess the total earnings change for the year. After all, the S&P 500’s value is made up of its annual earnings times a multiple.
With the coronavirus really starting to scare folks in America since early March 2021, we can make an extreme guess that March earnings will decline by 100%. Therefore, 1Q earnings will decline by 33% for the S&P 500.
Let’s make another extreme guess that 2Q 2021 earnings will again decline by 100% due to absolute paralysis. Nobody spends a dime on anything, not even on toilet paper online because the world ran out!
Let us then make another guess that 3Q 2021 earnings will decline by 30% as the economy recovers, but not to its original expectation. At last, hand sanitizer supply becomes more readily available in stores and hoarders who tried to price gouge get banned for life.
Finally, we can guess that 4Q 2021 earnings are flat. We’re back to our original spending amounts, which could prove to be conservative given the phenomena of “revenge spending.”
What is the total earnings decline for the year?
The baseline assumption is Quarterly earnings = 1 where 1 is the market assumption of earnings. It does not matter what the actual earnings numbers are. The other assumption is that the market trades based on expected earnings.
1Q: -33% = 0.67
2Q: – 100% = 0
3Q: -30% = 0.7
4Q: 0% = 1
Total: 2.37 out of 4 = -40.75% earnings decline.
We can now forecast that if valuations stay the same, the S&P 500 will decline by roughly 40.75% from its peak level of 3,386. In other words, under this earnings scenario, the S&P 500 will bottom at about 2,000.
The question you have to ask yourself is whether the above earnings assumptions are conservative, optimistic, or realistic.
In my opinion, the above earnings assumptions are a little too dire, even for the DIRE Movement founder. There is no way 2Q earnings will decline by 100%. Therefore, let’s make some further, better-educated guesses about quarterly estimates.
We know that the sectors hardest hit from the coronavirus are travel, hospitality, food and entertainment. Earnings in those sectors will probably go down 80%+. However, the Consumer Discretionary sector only accounts for about 10% of the S&P 500 in 2021.
The largest sector weightings in the S&P 500 are Technology (24%), Health Care (14%), Financials (12%) and Communication Services (11%), accounting for more than 50% of the S&P 500.
Therefore, instead of forecasting a 100% decline in S&P 500 earnings for the month of March, let’s forecast a 50% decline. As a result, 1Q 2021 earnings will decline by 15%.
Now let’s forecast a realistic 70% decline in 2Q 2021 earnings as citizens realize how serious the coronavirus really is. Although consumer spending will shift online and the Utilities and Health Care sectors may see flat earnings, let’s stay conservative.
For 3Q 2021, let’s forecast a 30% earnings decline as people gradually start spending again as the number of coronavirus cases and deaths decline. But some industries like the cruise industry will likely see a permanent structural decline in demand. People will still be on edge and save more than they normally do.
For 4Q 2021, let’s forecast no decline in earnings as consumers start spending more to “catch up” for the prior three quarters. It’s the holiday season, consumers are thankful to have made it through a scary time period and a bear market. Some might think there could be a YoY earnings increase. However, let’s stay conservative to account for job losses.
Here are the numbers where 1 equals previous quarterly earnings expectations by the market.
1Q: 0.85 = 15% decline
2Q: 0.3 = 70% decline
3Q: 0.7 = 30% decline
4Q: 1 = 0% change
Total: 2.85 = 29% decline in earnings.
If valuations stay the same, the S&P 500 will decline by roughly 29% from its peak level of 3,386. In other words, under this earnings scenario, the S&P 500 will bottom at around 2,400.
Given the S&P 500 has already declined past 2,400, a believer of this earnings model can either think the bottom is already in or will be buying the S&P 500 index under 2,400 again.
Personally, I believe there will be closer to a V-shaped recovery in demand at some time during the second half of 2021. Once the fear of the pandemic passes, American consumers will start to spend like there’s no tomorrow again. Therefore, I think my 3Q and 4Q earnings estimates could prove conservative.
One of the silver linings to emerge from the coronavirus pandemic may be that those people who had full-time jobs and keep their full-time jobs throughout the crisis will have more money in their savings account due to the lack of spending opportunities. With more savings, they should have more financial security and be better prepared to weather the next black swan event. They might even start practicing more sound personal finance habits.
Another potential reason for optimism is that the federal government could start sending households $1,000+/monthly checks as a form of Universal Basic Income until the pandemic is under control. UBI is probably the most effective ways to support Americans immediately and directly. Then there will be corporate bailouts to save potentially hundreds of thousands of jobs. Let’s just ensure there aren’t any mega-million bonus packages for executives this time around.
Admittedly, with the whole world shutting down, it’s hard for me to believe that 2,400 or a 29% decline in the S&P 500 marks the bottom of this bear market, especially since the average decline is closer to 35%. Everything feels hopeless, like it did in 2000 and 2008-2009. We also know that the market tends to overshoot on the way down. Therefore, it wouldn’t surprise me if we see closer to 2,000 – 2,200, bottom mostly due to extreme fear.
However, I do believe we will flatten the curve with social distancing and come out of this crisis stronger than before. Further, the S&P 500 yield is now higher than the 10-year bond yield.
Wherever the S&P 500 is when you read this article, I encourage you to calculate backwards the implied earnings estimates and see if they make sense. If they don’t make sense, then you should take action at your own risk. In finance, we call this a back-of-the-envelope calculation.
When the S&P 500 is below 2,400, I will hold my nose and buy some more. Then I’ll assess the latest information and run my earnings model again.
My plan is to continue buying on the way down and on the way up to get neutral equities and build a larger dividend income portfolio. I presume dividend payouts will be cut to preserve capital, but will eventually come back. It’s been a painful process so far, but I’m going to keep going like I always do.
Update August 20, 2021: The S&P 500 rebounded all the way back to an all-time high and the NASDAQ is up over 25% for the year. With so much equity profits, I’m now very focused on searching for lagging real estate deals now. I’m also happy to stack cash.