“We are now in recession. It is way worse than the global financial crisis,” IMF managing director, Kristalina Georgieva, said on Friday.
That global financial crisis caused the ASX 200 index to fall 54 per cent between November 1, 2007 and March 9, 2009. The MSCI global index fell 59 per cent.
The COVID-19 crisis, which I think we can agree is “way worse” than the GFC, has so far produced a fall of 30 per cent in the ASX 200 and 27 per cent by the MSCI.
Apart from that simple comparison, there’s another way to see that the stockmarket has come nowhere near to correctly pricing for the earnings recession now underway: in March 2009, the market price earnings (PE) ratio got down to about eight times; it’s currently 13-13.5 times, and that’s based on inflated earnings projections from analysts who haven’t yet put reality into their spreadsheets.
At its February peak, the ASX 200 was 7197 and the PE ratio based on consensus forward earnings estimates at the time was 18.8 times. By simple arithmetic we can see the earnings figure was 382 (7197 divided by 18.8).
On Friday the ASX 200 closed at 5107. The current market PE is said by analysts to have fallen to between 13 and 13.5 times: 5107 divided by 13.3 is … 383. READ MORE:Rubicon crossed on fiscal spending|Fund managers count the cost of virus
So in other words, if that’s correct and the market PE has come down to 13.3, then earnings are forecast to be unchanged next year. Alternatively, we could say PE is still 18.8 which means the “E” for earnings is expected to fall by 29 per cent (5107 divided by 18.8 is 272, which 29 per cent below 382).
Both of those ideas – steady earnings or steady PE – are obviously bonkers, so maybe the truth lies somewhere in between - say a PE of 15 and a 15 per cent decline in earnings, which also produces an ASX 200 value of 5107.
Nah, that doesn’t make sense either. A market valuation bottoming at 15 times – which is above the long-term average - in a worse economic downturn than the GFC? And average earnings declining by only 15 per cent? Can’t see that.
But then again, this time is different for two important reasons: fiscal stimulus this time is earlier and far bigger (10 per cent of GDP so far versus 4 per cent in 2008-09); and second, monetary policy and low inflation means the 10-year bond rate is 0.75 per cent.
The PE is partly a function of prevailing interest rates. Investing is mostly relative, and the constant question is: how does the return from risky equities compare with return from risk-free government bonds?
In 2009 the bond rate was 4 per cent. At eight times, the market PE at the bottom represented an earnings yield of 12.5 per cent (earnings yield is the inverse of the PE, and theoretically captures both dividend and capital growth) – so it was a spread, or “equity risk premium” of about 8 per cent at the time, which certainly made the risk of investing in equities worthwhile. It’s usually more like 3 per cent.
A similar premium over the current bond rate would see the earnings yield at 8.75 per cent and PE at 11.5 times – quite a bit higher than the GFC low, but lower than it is now.
A PE ratio of 11.5 and, say, a 20 per cent decline in average earnings would result in an ASX 200 value of 3514, 30 per cent below where it is now. A 10 per cent decline in earnings and a PE of 11.5 would mean a further 22 per cent decline in share prices.
To put it another way: for the current level of the ASX 200 to be right for a PE of 11.5, the consensus analyst forecast for earnings next year would have to be an increase of 16 per cent – the most bonkers idea of all.
These calculations are all very interesting, but the truth is that “Mr Market”, as Benjamín Graham called it, is not a rational creature that behaves according to neat arithmetic like that, but is given to fits of emotion.
“Often,” Graham wrote in The Intelligent Investor, “Mr Market lets his enthusiasm or his fears run away with him, and the value he proposes seems to you a little short of silly.”
That is, Mr Market tends to overshoot, both on the way up and on the way down.
One saving grace is that the coronavirus struck before Mr Market got too carried away on the upside: the peak PE of 18.8 was more than the 17 it got to in October 2007, but well short of the 23 times reached in the blowout top of September 1987, before the crash the following month.
The market was a little expensive in February, but not a bubble. Is it cheap yet? Nope, nowhere near it: it’s cheaper, but it is not cheap.
ALAN KOHLERFollow @AlanKohler
