S&P 500: Brace Yourself For Earnings Contraction

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Thesis

About 40% of the stocks listed in the Nasdaq 100 index have touched -50% from their 1-year highs. As the market is crashing, many investors like to consider the current environment as a buying opportunity. However, there is at least one good reason to disagree: a recession-driven EPS contraction will likely push the market even lower. Moreover, investors should note that a depreciating stock is not always a buying opportunity. History has shown that many stocks have the ability to go down and never look back. Personally, I estimate that the S&P has another 20% downside–approximately, given that the street’s consensus estimates do not reflect any significant EPS contraction. My target price for the S&P 500 is 3,200 and for the Nasdaq about 10,000.

Where we are in the downturn

The S&P 500 is down about 20% YTD. While such a drawdown is clearly unfortunate, it actually doesn’t fully capture the pain in the market. Notably, if we consider the Nasdaq 100, about 40% of the index’ constituents have lost more than 50% of their valuation (Date 6th June 2022). Also Cathie Wood’s ARK Innovation ETF suffered about -50% YTD (Date 20th July 2022).

Seeking Alpha

Notably, bearish-positioning in futures remains highly elevated and might provoke a short-squeeze. This, however, should not push investors to buy into equities. The trend in the market is undoubtedly downwards and any bear-market rally/short-squeeze is likely to get sold-off. Given the short-duration focus of investors and the risk-averse sentiment, value has outperformed growth and defensive sectors such as energy, consumer staples and utilities performed better than technology and consumer retail. The S&P 500 is now trading at a x19 P/E. According to analyst consensus estimates, the one-year forward P/E is x15.9.

Another leg lower given EPS contraction

However, the S&P is not really pricing any EPS slowdown. During the past few months, the S&P revaluation has been largely driven by rising interest rates, which caused a multiple contraction given the value depreciation of long-duration cash flows (high P/E). Personally, I believe the market must still price an EPS slowdown, which we will likely see in the 2H 2022/1H 2023. Considering wage inflation, higher commodity prices, lower sales volume, and the potential for elevated tax rates, almost all lines in a company’s income statement appear threatened. That said, I believe the broad market has likely room to trade another leg lower. Given a 15.9 P/E and a 15% EPS contraction, I see the S&P fairly valued at about 3,200 and the Nasdaq 100 at about 10,000. Please be aware that my 15% earnings contraction estimate is a subjective judgment, which could be grossly understated. Most notably, whenever an asset-bubble broke in the past, earnings contracted by more than 50% within a 2-year time-period. After the roaring twenties bubble, earnings for the S&P 500 fell from $1.60 in 2029 to $0.42 in 1933. contracted by more than 50% After the dot-com bubble, earnings contracted from about $53 in 2000 to about $24 in 2002. After the housing bubble, earnings fell by more than 90%: from $84 in 2007 to $7 in 2009. Currently, S&P earnings are at $203. I am not saying that earnings will necessarily contract by more than 50%, I am just open to the possibility–and believe that every conservative investor should.

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Not Every Sell-Off is A Buying Opportunity

At this point it is worth noting that not every sell-off translates into a buying opportunity. Especially if we consider the deflation of a bubble, or a super-bubble as the covid-19 induced asset bubble has been called by Jeremy Grantham, investors must have lots of patience. Most notably, after 33 years since the Nikkei touched 40.000 the Japan equity index is still 30% below the index’ peak. Moreover, single-stock picking performs even worse. One of my favorite research notes ever written The Agony & The Ecstasy, by J.P. Morgan, highlights that about 40% of stocks experience catastrophic losses”, which are defined as -70% sell-offs that never recover. That said, Cisco peaked in March 2000 at a valuation of about $90/share. After 22 years, the stock still trades -40% from peak. Similarly, General Electric sold-off from $400/share and has never looked back. Or consider Citi: After the financial crisis, the stock has never traded at anywhere close to the >$500/share valuation. Most notably, my examples are not referencing frauds, or anything similar, but global companies with a competitive and sustainable business model.

What to avoid

There are a few sectors where I personally would be very cautious buying any dip. These sectors are Green Technology, Cyber Security and anything related to Food Delivery/Gig Economy. In my opinion, these sectors have seen too much speculation during the past 5-years asset-price inflation. And despite a 20% – 30% drawdown, valuations are still very rich as compared to the broad market. For example, many companies in the cyber security industry trade at PE multiples considerably above x50, e.g., SentinelOne (S), Fortinet (FTNT), CrowdStrike (CRWD)—representing a 200% premium to the S&P 500. Even if the cyber security continues to grow strongly, which I do not doubt, it would take these stocks multiple years to grow into their rich valuation. I am even more bearish for the gig economy stocks, especially food delivery. As argued in my article about DoorDash, I see these business models as structurally unprofitable and I would completely avoid any exposure until their management have proven me wrong.

Conclusion

I believe the market is going lower and I see approximately 20% downside for both the S&P 500 and the Nasdaq 100. In my opinion, the market has not priced any considerable EPS slowdown. As I price a 15% EPS contraction, I see the S&P fairly valued at about 3,200 and the Nasdaq 100 at about 10,000. Please note, however, that whenever a bubble has burst in the past, EPS contracted by more than 50% from peak. In my opinion, such a scenario should not be ignored when considering if the current market is providing opportunity.