Back in 2018, I did a ‘back of the envelope’ analysis of what’s the downside for stocks (as represented by the S&P 500) in the event of an unforeseen panic. That is, with hindsight, you can call it a panic, but most didn’t see it coming. That’s what makes it a panic.

This goes to having a plan. A key part of which is understanding valuation.

What follows is not a ‘call’, it’s a scenario to get an idea where valuation could go, and accounting for this in your potential investments. Following that, I’ve got a few takeaways.

Here is a worksheet showing the calculations for a ‘panic scenario’: panic-scenario-20200309

The key variable is an ‘equity risk premium’ – this boils down to how much excess return will investors expect and demand from equities over ‘risk free’ government bonds to compensate for risk.

Many use the 10 yr treasury as the risk free benchmark. I used the 5 yr, as who the hell can forecast 10 yrs out (let alone 5)?

The expected return of equities is deemed to be the expected earning yield, or 1 / forward P/E ratio

The big ‘insight’ in the whole calculation is that over the period from 2000 to present (I couldn’t get older data on short notice), if we look at episodes we label as a ‘panic’, we can see that the extreme expansion of the equity risk premium from the onset to the maximum excursion of this premium seems to be about 3%. Sounds like nothin’, right? It has a big impact, especially when the risk premium starts out low, like 2.9% as it (approx) did at the recent market top on Feb 19, 2020.

With this in hand we can do some simple calculations, given a few assumptions on where the earnings yield of the SPX can end up being priced, the implications for the ‘target’ price of the index, and a few rules for trying to pick longs at least.

In such a panic, an 8% implied earnings yield is not out of the question. That’s a 12.5x P/E, and with an assumption of a mild 5% decline in earnings estimates (analysts are always slow to adjust) the implied level of the SPX is 1700. Again, not a call but a scenario. Use your own judgement. And there’s nothing said here about overshoot.

My inclination is to look at potential longs through this lens, preferring things already reflecting such a compression in valuation. Obviously different stock trade at a premium or discount to the market, and that can be taken into account.

For instance, yesterday I did some light buying of double-digit yield stocks I have reason to think are solid and 1 stock with a low single digit P/E whose business should be off the hook the lower yields fall. Doesn’t mean they can’t get cheaper.

A few other guide posts I am looking at:

#1 For non-financial businesses, one indicator of a good business is Return on Assets. Very high number here are often unsustainable, so companies with good records here show evidence of a moat. For example, in tech, look at MSFT, ORCL, GOOGL – although this says nothing of valuation. But clearly, consistent high ROA businesses may deserve higher multiples. At ORCL, Larry Ellison still owns a huge stake and IMHO was one of the most consistent value creators over time. The company had an early brush with bankruptcy and learned from it.

#2 Use Total Assets / Total Equity as a ‘cleaner’ proxy for leverage. This can also reflect over-valuation of assets. In the GFC, I looked for around 3x max.

#3 Current and Quick Ratios may reflect a company’s resilience to short term cashflow turbulence. The higher the better. Under 1 and it starts to get dicey.