Nothing's Working for Stocks Except the Math

(Bloomberg Opinion) -- There’s really only one sure thing in markets, and that is the longer a rout in stocks goes on, the more esoteric the analysis put out by Wall Street to explain the moves and guess when the carnage may end. Examples range from the relationship between bond yields and dividends to something euphemistically called “technical analysis” that attempts to divine future prices from squiggly lines on a chart.

None of it seems to work, because nothing can accurately predict human fear and emotion. As economist John Maynard Keynes said: “The market can remain irrational much longer than I can remain solvent.” So instead of trying to read too much into the S&P 500 Index’s 4.94% rebound on Tuesday from its gut-wrenching 7.60% drop the day before, it’s best to understand where markets are valued through the simplest of math. As of the end of last week, the benchmark traded at about 18.3 times earnings based on a level of 2,972. (It ended Tuesday at 2,882.23.) That implies corporate earnings of $153 per share for this year, well below the $172 estimated by Wall Street, according to BNY Mellon strategist John Velis. Now, nobody believes those forecasts — made in calmer times — will be achieved, but flat earnings growth is probably a baseline assumption at this point. Such a scenario translates into a price-to-earnings ratio of 17.5 times and a level of just under 2,900 for the S&P 500, Velis wrote in a recent research note. For the pessimists who might expect earnings to plunge 25% and P/E ratios to collapse to an apocalyptic 12.5 times, the S&P 500 would fall just below 1,450 for a decline of about 50%. So, the market could get better or it could get worse — that’s just the way it is.

“Even a smallish 15% hit to earnings growth, combined with typical equity de-rating, paints some concerning market scenarios,” Velis wrote. “A slightly worse corporate profits scenario (say, a 25% earnings decline) makes dire reading, indeed.” This is not to cause panic, but rather to help provide an understanding of stock valuations based on varying assumptions, and see how that may be playing into the movements we’re seeing now.

SAFETY HAS ITS LIMITSPerhaps the most encouraging news for the stock market on Tuesday came out of the bond market. One could make a strong case that the collapse in U.S. Treasury yields in recent weeks has led equities lower, rather than the other way around. Bonds, more so than stocks, are pricing in a dire economic outlook, with a severe recession a strong possibility. But at the Treasury Department’s monthly auction of three-year notes, traders bid for only 2.2 times the $38 billion of securities offered. That’s the lowest bid-to-cover ratio since December 2018 and down from 2.56 at last month’s sale. What this shows is that bond traders, who have a reputation for having a better handle on the economic outlook than stock traders, aren’t panic buying safe government bonds at any cost. In that sense, the message may be that the worst is over and markets may be returning to more orderly daily moves. The auctions continue Wednesday with the sale of $24 billion in 10-year notes and the sale Thursday of $16 billion in 30-year bonds.

OIL WAR TURNS INTO CURRENCY WAROil prices around the world plunged on Monday by the most in more than a decade following the collapse in talks between Saudi Arabia and Russia on bolstering crude production. Saudi Arabia wanted to support prices by limiting production, while Russia wanted to pump as much oil as possible; when Russia refused to budge, Saudi Arabia launched a price war by offering discounts to customers and promising to open its spigots. On Tuesday, Russia made clear it has no intention of backing down from its stance, bringing forward foreign currency sales and raising cash to brace for further turmoil in oil markets. The result was a 4.57% tumble in the ruble, the most among the more than 30 major currencies tracked by Bloomberg. The sales would normally have started next month, according to Bloomberg News’s Natasha Doff and Áine Quinn, but Russia’s Finance Ministry said it would sell foreign currency as long as oil prices stay below $42.40 per barrel. Russia is such a large component in emerging markets that a prolonged effort to weaken its currency may put pressure on other emerging market economies to do the same in order to stay competitive. The downside is that mass devaluation of emerging-market currencies would only exacerbate the pain their economies are experiencing.

TRUMP’S PYRRHIC OIL VICTORYIt was almost one year ago that President Donald Trump tweeted that it was “very important that OPEC increase the flow of Oil. World Markets are fragile, price of Oil getting too high. Thank you!” Naturally, he followed that up Monday by tweeting: “Good for the consumer, gasoline prices are coming down.” Indeed, regular-grade gasoline prices as measured by the Automobile Association of America have fallen to $2.365 a gallon from this year’s high of $2.600 in early January. Deutsche Bank strategist Torsten Slok wrote in a note to clients Tuesday that it could soon drop to $2 a gallon. There’s no doubt that the drop in gasoline prices could be a potential boon for the U.S. consumer. Citigroup’s economists estimated in a research note that it may add as much as $125 billion in extra disposable income to consumer wallets. But these are hardly normal times, with the spreading coronavirus likely to keep Americans close to home instead of going out and driving their cars. The Citigroup economists seem to acknowledge as much, noting that “discretionary consumer spending is typically the key beneficiary when retail gas prices decline, so a more cautious consumer in the current environment is likely to pare down the upside effect from lower oil prices in the near-term.”

ITALY MATTERSThe number of confirmed coronavirus cases in Italy officially surpassed the 10,000 mark on Tuesday, with Prime Minister Giuseppe Conte calling on the European Central Bank to help shore up what was already a flagging national economy. Conti evoked the “whatever it takes” language that came to symbolize the ECB key role in stabilizing the euro area in 2012, Bloomberg News reported, citing a European official. When it comes to Italy, European officials shouldn’t view aid as a handout, but rather as a necessity because the stakes are too high. Italy has about $2.3 trillion of government bonds outstanding, making it the world’s fifth-biggest debtor behind the U.S., China, Japan and France. A crisis in confidence here could quickly escalate into another global crisis. The nation’s bonds offer the euro zone’s highest yields outside of Greece to compensate investors for the strong degree of uncertainty and large debt load. Italy’s 10-year notes yielded about 2.27 percentage points more than similar-maturity German bunds on Monday, the most since August and rapidly expanding from 1.29 percentage points a month ago.

TEA LEAVES The collapse in bond yields has resulted in a big drop in mortgage rates. Freddie Mac said last week that average rates on a 30-year home loan dropped to an all-time low of 3.29%. They are likely to be even lower when Freddie Mac provides an update Thursday. The upshot is that scores of homeowners are able to refinance at lower rates, providing monthly savings that dwarf what they would enjoy from lower gasoline prices. Markets will get an update on the latest refinancing activity Wednesday when the Mortgage Bankers Association updates its weekly refinancing index. That gauge rose last week to the highest since 2013, and there are many reports of lenders quickly shifting workers to their mortgage departments to handle the flood of refinancing requests. The downside is that the lower rates don’t seem to be helping purchases of homes. The Mortgage Bankers Association’s purchasing index actually fell last week and is in line with its average over the past 12 months.

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To contact the author of this story: Robert Burgess at bburgess@bloomberg.net

To contact the editor responsible for this story: Beth Williams at bewilliams@bloomberg.net

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

Robert Burgess is an editor for Bloomberg Opinion. He is the former global executive editor in charge of financial markets for Bloomberg News. As managing editor, he led the company’s news coverage of credit markets during the global financial crisis.

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