What’s the Market Worth?

The Coronavirus outbreak has blindsided markets since mid February, with equities down nearly 30% off their peak. What investors need at this juncture is a line of sight on valuations, to get a sense of what sort of scenario this sell-off represents. Analysis of this sort is vital to build a profile of the probability landscape around different coronavirus outcomes.

There are two drivers of the sell-off:

1. Projected Earnings hit: the extent to which earnings are impacted is hard to gauge but will be pronounced. The market anticipates a raft of downgrades.

2. Increased uncertainty: we have little idea what to expect in terms of the length or extent of the disruption to the economy caused by this virus. Because we can’t quantify anything, realised financial market volatility becomes extreme; making equities a less attractive investment on a relative basis to alternative investments.

We can look at quantifying the impact of point 1 and 2, to get an idea of what sort of scenario the market is pricing in; and to make a decision, given the virus data that we can track, as to whether equities is likely too bullish or bearish.

Increased Uncertainty

One of the hallmarks of financial markets over the last ten years has been anaemic volatility. Driven ultimately, in our view, by a total absence of inflation, it has been a key driver of making equities incrementally attractive and driving up the market’s fair multiple.

Let’s estimate the relationship of volatility and fair multiple. As fear and risk perception elevates, the fair multiple collapses. Conversely, as visibility and a line of sight appears on earnings and the economic hit, volatility will progressively moderate, and the fair multiple of the equity market rises.

In order to quantify the relationship, Resonant has built a simple model to estimate the sensitivity of fair multiple to the implied volatility index (S&P/ASX 200 VIX Index). Clearly, this is an exercise in educated guesswork, we still feel that a rough estimate is better than no estimate at all.. It is however no substitute for following the markets closely over this period, but it helps enhance the research process.

To estimate our relationship, we look at historical data on the Australian Equities market between 2010, when the VIX series starts, and end of February 2020.

Figure 1: S&P/ASX Australia VIX (LHS, source S&P/Refinitiv) vs Equity Risk Premium (Source: Resonant Asset Management)

Based on the relationship, we have quantified every doubling in VIX, to a 1% increase in the risk premium (ie. The equity market sells off).

Earnings Hit

Volatility and earnings are intrinsically linked. Only now are we starting to see economists quantify the full impact of the virus on the domestic economy. We are looking at two quarters of negative GDP Growth for Australia, should the lockdown succeed and the virus be contained. Citi is forecasting that GDP will contract by 4.4% over 2020 (See: Forecasting the largest percentage change GDP growth contraction in history, 24th March 2020, by Josh Williamson, Citi Economics Research)

If we assume that the stock market is an adequate representation of the economy – then we can project sales revenues (as opposed to earnings, which will be much more pronounced) for companies to fall approximately 5% over 2020. The disparity in outcomes will be huge, with some industries (tourism, travel), impacted far more than others (healthcare, supermarkets, cloud computing).

To translate the sales/revenue hit to earnings we need a sense of where corporate margins sit. And their likely trajectory. Shareholders ultimately should care about Net Margins, which have a cyclical component, and a policy component, amongst other things.

Cyclical Component: We would expect that aggregate margins would fall, as companies face fixed costs of keeping the lights on, regardless of broader conditions.

Policy Component: Governments look to cushion the blow as much as possible, by implementing tax policies and stimulus to minimise the hit to margins.

In addition to the revenue hit, we need to estimate the margin hit, to get a sense of impact on earnings.

Currently the weighted average net margin for an S&P/ASX 100 ex Financials company is currently 13%. As you can see it has fluctuated with Commodity prices in particular – the trough being in late 2015.

Figure 2: Index weighted 12m forward net margins for the S&P/ASX 100 index (source: Resonant Asset Management calculations, Refinitiv data)

Over the next twelve months, what can we possibly expect to happen to Net Margins, Revenues and Earnings?
In order to answer this question, we’ve put together a matrix of outcomes, broadly splitting the economy into V-shaped (12 weeks), U-shaped (2 quarters), and L-shaped (1+ years).

Figure 3: Approximate Revenue, Net Margins under different macro-economic scenarios

Market Projections

We think the VIX will settle around 25-30 at the end of March, and trend towards 20 for the rest of the year, as uncertainty as to the course of outcomes for this virus continues to play out. For us to get to 20, we would need a clear example of a western democracy that has successfully managed to “flatten the slope” and manage the hospital overload. For example, if Italy were to consistently and successfully slow the increase in cases, then that would bring market volatility right down, as it would demonstrate to other countries what is required to achieve this, and on what timeframe.

We suspect that if the social distancing and lockdown policies in Italy have been successful, then we are looking at a U-shaped recovery for Australian corporate earnings.
That means 12 month margins of 10% (from 13%) and a 5% revenue hit, in total a 30% hit to earnings.

Figure 4: What’s the Market Worth Under Different Volatility, and Earnings outcomes

We see our base case described above, where the market is worth 5019 points, a U-shaped recovery, 5% negative GDP Growth, and a volatile equity market to the order of a VIX at 20 from April for the next 12 months, as a price target just a tick above 5000. That would correspond to a yield of around 4.5% plus franking, and an additional 5% upside from the close price on the 24 th of March.