This post was published on March 18, 2020 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.
A Simple Exercise On Predicting A Stock Market Bottom
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 2020, 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 2Q2020 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 3Q2020 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 4Q2020 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.
When Will The Coronavirus Stock Market Bottom Be?
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 2020.
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, 1Q2020 earnings will decline by 15%.
Now let’s forecast a realistic 70% decline in 2Q2020 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 3Q2020, 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 4Q2020, 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 2020. 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, 2020: 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.
In 2018 I was able to invest a lot of money in the stock market and I did. Now, I am thinking I should have sat on that cash and waited for the next decline or bear market as we have now to join in. Of course, I have reaped in dividend income and I have bought what I can now, but the majority of my assets are in the red as I seem to be adamant to not ever selling at a loss. Maybe I should just accumulate cash for the next few years and invest it at the next bear market which I understand will be in 5 or 6 years.
How do you think the inevitable second wave of outbreaks and possible resulting quarantine will effect your spending predictions? What do you think unemployment will be at by year’s end?
I think a second outbreak is expected and we will be much more prepared after going through current measures. As a result, I think we will deal with the second outbreak better and feel less shock if we have to quarantine again.
I think unemployment surpasses 40 million, and ends the year at around 20-25 million. The government enhanced unemployment benefits, stimulus checks, and PPP loans have really been solid so far. The most decisive and proactive I’ve ever seen.
As of April 30, 2020, I sold all my stock I bought below 2,500, and also took some profits on stocks that rebounded, like Tesla.
See this post: Freedom Is Much More Valuable Than Money
Just took out a $100k heloc on our house. We have another $250k in equity still even if I spent all the heloc. What I plan on doing is leveraging it in the stock market, a little at a time. Especially if we dive down another 20-30% from current levels. I see little risk in this move if we keep our jobs. Which is why I’m being cautious with leveraging this money. What’s a good entry point in your prediction?
Did you decide your entry point? I basically looked at Sam’s data (17 months for average bull market) and decided to DCA across 17-20 months, a combo of index funds mostly.
Sam, thanks for all you do. What sector of stock market will be good to invest moving forward in 2020 for the next 1-3 years? Because of this coronavirus, will people now hear more about what Bill Gates says to invest in healthcare? What brought stock equity up from 2009 to 2019? Technology? What will it be now?
Thanks!!!!
The stock market is not a market. Now it is a federal reserve manipulated investment. Why would anyone even think about any investment at this time
when the Federal Reserve at anytime on any day with there unlimited funds can move the market up or down. Get out and let them have it. Free market no more when your investment has no impact.
Agreed. If Covid were a blip, and if the Fed just offered *some* intervention rather than the current extreme intervention, fair value for the S&P500 would be 1800 +/-200. In the first round of SBA loans, 1.6 million applications were accepted, but there are 30 million small businesses. Given that info, I’m betting this will be a train wreck rather than a blip. I’m getting ready to sell the investments I purchased @ the late March bottom I believe the real economy is ultimately more powerful than Fed intervention, although I may be proven wrong since the Fed has lost all sense of responsible levels of support.
I sold a condo in October 2018 and have been sitting on 400k in cash and was really bummed when it wasnt in the market in all of 2019. I was itching to get in but just couldn’t do it because valuations were so high and it just seemed like prices just couldn’t keep going up. Today I feel very relieved as now I can start buying much more comfortably knowing I didnt buy at the top. Should I go all in on a diversified oil fund considering it’s gotten so hammered on multiple fronts?
As an oil industry person, I’d advise against oil investing unless you take time to understand the debt risk on a per company basis. There will be bankruptcies that may hurt portfolio type funds.
Thanks Tim. What big players in oil do you think are in the strongest position to make it through this storm?
Some of your more solid players that will make it through are
PE (parsley Energy) – good rock, good neighbourhood
MGY (among the best) why : lives within cash flow, low debt.
DVN (large cash pile on balance sheet) dislike Mgmt. good company though.
speculative
SM (high debt), good rock
AR (high debt), good mutl-year hedges
Sam – great analysis. I believe there needs to be an adjustment to earnings on a go forward basis to account for the debt service that companies that get bailed out must pay. For example, if Boeing gets a $50B loan @ 0% interest that is payable over 10 years they will be paying ~ $500M annually back to the government. The $500M will be a reduction in earnings. In 2019, Boeing had a net loss of $636M (-$1.12 EPS). This would increase their loss to $1.14B (-$2.01 EPS). That is an almost 80% decrease in EPS. This concept will have a material impact on the aggregate PE ratio across the market.
Once the bailout package is announced it will be easier to calculate the potential impact, but I suspect we would want to incorporate this into the analysis to better understand the potential downside. This will be a long lasting impact on earnings until the debt is repaid.
Jordan,
Quick question on your math. If Boeing were to get a $50b loan with a 10 year term. The annual principal would be $5b no? Also debt would not be calculated in EPS, as the debt would be a balance sheet issue. Now I would agree that FCF would be impacted, but not exactly sure on your EPS calulations.
Seems reasonable.
The market seems to assume the worst at this point.
-We assume gloom due to our borders and tourism being shut down.
-We assume nationwide unemployment upticks because of social distancing.
-We assume the number of people ill to increase.
The only thing in my opinion that could drive it down/up drastically are the numbers after the dust clears:
-Unemployment numbers
-Earning reports for major market movers (FAANG, etc.)
-Approval/rejection of key bills (bailouts, UBI, etc.)
-Random events (Top 10 politician getting COVID, major natural disaster hitting while the country is basically shut down.)
I am personally going to increase my Roth/401K contributions since this could be a good entry point.
The market is tainted. Keep it tangible, real estate works. Also lets give all the big corporations a big fat bailout and a trophy for last place. One rental house can replace the income from 300,000 in a 401k.
The market is tainted for sure.
If a bailout happens I hope they are HEAVILY regulated and held accountable.
I want to do Real Estate but it’s kind of early.
1. I am 2 years out of college. Within a year I may have enough for a down payment.
2. I still want to take advantage of the employee match for the 401K (Free money.)
3. I am in Texas now, but I don’t know how long I will stay. My concern is that If I ended up moving say to Colorado, it would be 10x harder to manage my rentals.
Having said that, I am interested in Real Estate.
Depending on different factors, I have considered investing in RE in Mexico since my dad works in the industry as an architect and we are close with the company owner. The combination of knowing people who KNOW the market and my relative buying power make it interesting.
Gold, Silver,real estate and toilet paper. Best investments
True that, best bet so far.
Yes, Gold if you already had it, an income source.
Be careful when investing in real estate at the moment. I own my properties outright. Because of that, I stand no chance of losing them if tenants fail to pay rent. Even then I could still get myself in trouble if I fail to keep enough cash on hand to pay for taxes and repairs. I’m not at all trying to dissuade you from buying real estate. But please do your homework. No over- leverage right now. Make sure you buy in an area that people are moving to, and unless you’re extremely handy and have oodles of extra time and cash on your hands, avoid anything needing too much work. Then once you’re in, screen, screen, and screen some more. Empty units are far preferable to bad tenants. When I first got into rental properties twenty years ago a family friend who owned and still owns a ton of rental property said to me that there’s nothing a property management company can do for me that I can’t do for myself and do better. I have lived by that ever since. Therefore it is not exactly a passive game.
Two cents:
1) Valuations are not based on past earnings… they are only used as a proxy for future earnings. If your future is bright and your past is not, your valuation will still be great (if not ask Uber, Skype, and the likes).
2) cero activity does not equal cero earnings… it equals big loses!
Best!