Pandemic + Recession = Multiple Expansion?

By Charlie Bilello

12 Dec 2020

The S&P 500’s P/E ratio has moved from 20.6 at the start of 2020 to 30.3 today, on pace for the highest year-end multiple in history.

Data as of 12/11/20

How is this possible in a year with a global pandemic and the largest economic contraction since the Great Depression?

Investors are anticipating much brighter days ahead, with the vaccines bringing an end to the pandemic and a v-shaped recovery in the economy and earnings.

The turnaround in earnings is already underway, with a 4% decline in the 3rd quarter (year-over-year), up from -33% YoY in Q2 and -49% YoY in Q1.

Forecasts are for S&P 500 earnings to hit new highs by the 3rd quarter of 2021.

As for the economy, we saw a sharp rebound in the 3rd quarter with a real GDP decline of -2.9% (vs. -9% YoY in Q2). This rebound is expected to continue into 2021.

Getting back to current valuations, what does a P/E or 30x mean?

The denominator of the P/E equation is short-term depressed from the earnings collapse, pushing up the multiple. If earnings continue to recover in the coming quarters as investors are predicting, the P/E ratio will come down (absent a larger move higher in stock prices).

Does that mean stocks are cheap today?

Not exactly. Even if we were to use 2021 forecasted earnings, the S&P 500 would be trading at 22x today. That would be its highest year-end multiple since 2001.

Is there any comparable periods to today?

While there are certainly parallels to the past, every time is different and 2020 has been the embodiment of that principle.

  • During the 2008 recession, we saw a larger earnings collapse (-40%), but stocks fell 38.5%, meaning multiples only expanded slightly (from 17.8 to 18.2).
  • During the 2001 recession, earnings also fell more than this year (-30.8%). But again, stocks declined 13% in 2001, meaning a smaller multiple expansion (23.5 to 29.6).

The difference in 2020 has been that while earnings have declined 23%, stock prices have risen 13%.

We saw something similar to that in 1991 at the end of the 1990-91 recession, where earnings declined 14.8% while stocks rose 26.3%.

In 1991, however, P/E ratios expanded from 14.6x to 21.6x. This year they have moved from 20.6x to 30.3x.

Many have argued that higher multiples are “justified” today given the Fed’s 0% interest rate policy. Perhaps, but the Fed maintained 0% policy from the end of 2008 to the end of 2015 with the S&P 500 trading at an average multiple of 17x (using TTM earnings).

So why are multiples so much higher today?

As Graham and Dodd once said, in the short run “the stock market is a voting machine rather than a weighing machine.”

What they meant: sentiment is all that matters in the short run (changes in the multiple investors are willing to pay) while in the long run fundamentals increasingly become more important (what are the actual stream of earnings and cash flows).

Rarely has the voting machine been more optimistic than it is today. It remains to be seen what the weighing machine will have to say about that in the future.

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