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Has the U.S. stock market stopped discounting the long term? It certainly appears that way, since during the coronavirus pandemic the market has become hyper-focused on the extremely short term. Stocks will plunge or soar on the slightest daily steepening or flattening in the coronavirus infection’s curve, for example.
It seems hard to square that behavior with the notion that the stock market discounts changes that are coming down the pike that are still years away. After all, no one doubts that eventually we will recover from the coronavirus and the U.S. economy will return to some sense of normalcy. Why, then, does the stock market trade 20% below where it stood in February?
The answer boils down to one word: Uncertainty. Increases in uncertainty have a surprisingly toxic effect on the stock market’s fair value.
The market’s reaction is not necessarily irrational, in other words, even if we assume the market was fairly valued at its February high.
To explain why, consider the discounted cash flow (DCF) model, which is widely used to assess the potential worth of not just stocks but any asset. DCF calculates the present value of future cash flows the asset produces. The key variable in the model is the discount rate — the amount by which we discount amounts that may be earned in the future. The higher the discount rate, the less that future cash flows are worth today.
To illustrate the huge impact of a higher rate, consider what the S&P 500’s SPX, +1.44% fair value would be under several discount rate assumptions. The calculations, which are summarized in the table below, were conducted by Vincent Deluard, head of global macro strategy at INTL FCStone.
(To be sure, Deluard had to make a number of other assumptions as well. But playing around with those assumptions turned out to have far less impact on the S&P 500’s value than changing the discount rate. For the record, Deluard assumed that corporate revenues in the first quarter of 2020 will be 25% lower than their year-ago 2019 level and 50% lower in the second quarter. He then assumed that revenues would start to recover and, by the end of 2021, would be back to their pre-COVID-19 trend. He also assumed that the 10-year Treasury yield TMUBMUSD10Y, 0.725% would be steady at 0.8%, which is close to where it stands today.)
|
Implied discount rate |
S&P 500’s fair value |
|
10.0% (current estimate) |
1,800 |
|
9.8% (long-term average) |
1,851 |
|
8.6% |
2,237 |
|
7.7% |
2,600 |
|
6.2% |
3,386 (Feb. 19 high) |
Here’s how to read Deluard’s results: Given his assumptions, the S&P 500 would have been fairly valued at its Feb. 19 high if we assume a discount rate of 6.2%. If we instead assume a discount rate that is equal to the long-term average, then the S&P 500’s fair value falls to 1,851 — 45% lower than its Feb. 19 high.
The discussion up until this point leads us to the crucial question: How much has the stock market’s discount rate grown since the coronavirus outbreak?
Deluard says that the bond market has already answered the question: The spread between investment grade bond yields and the risk-free rate has increased by between 1.5 and 2 percentage points, while high-yield bond spreads have risen by between 5 and 7 percentage points. The average of these is 3.8 percentage points, and if we add that average to the implied rate at the Feb. 19 high, we get a discount rate of 10.0%.
That translates to an S&P 500 fair value of 1,800.
Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at mark@hulbertratings.com
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