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What's The Worst That Could Happen?

Via ConvergEx's Nicholas Colas,

The 30 stocks of the Dow Jones Industrial Average currently trade for an average of 14.8x next year’s consensus earnings.  But... Everyone knows Wall Street analysts are always too optimistic, so what if we just look at the lowest estimate for each company?  That “Worst Case scenario” P/E is 16.7x – not "Cheap", but not crazy expensive either – and incorporates a decline in earnings from 2015 of 1.5%. 

 

As tempting as it is to say “Buy stocks” with this math, the truth is hazier. In reality, markets currently discount this “Worst case” as the “Base case”.  With the 10 year Treasury yielding 2.1%, that 16.7x multiple is where stocks should actually trade.

 

The driver of this market pessimism sits at the top of the income statement – the Street’s worst case revenue estimates call for a decline of 1.7% in 2016.  Now, Q3 earnings season is unlikely to provide much comfort here; why should corporate managements go out on a guidance limb when their stocks are down on the year?  All this points to further volatility in October, and with a bias to the downside.

Of all the words of tongue or pen, the dumbest are these: “What’s the worst that could happen?”  I imagine every stupid stunt ever uploaded to Youtube started life with that question.  Skateboard off the roof of your parent’s house into the pool…  Taunt the chimps at the zoo…   Jump a bike over 17 of your friends…  That phrase is cursed.  Even a movie of the same name, starring Martin Lawrence and Danny DeVito, only has a 10% approval rating on Rotten Tomatoes.

In financial markets, however, this is one of the most important questions you can ask.  A few examples:

Every hedge fund uses some form of risk management to understand the worst case scenario for their portfolio. In general, the larger the firm and more complex the strategy, the more elaborate the analysis.

 

Central bank policy makers clearly think about this question as well, and someone at the last Fed meeting must have asked “What’s the worst that can happen if we raise rates by a quarter point?” They apparently heard an earful in return.

 

Traders are probably the most adept at thinking in these terms. Take, for example, the old “Three day rule” – never buy a stock that’s broken to a sharp new low for at least three trading days.  The reason?  Something bad clearly happened, and you have no idea how much worse it will get.

One place where you seldom hear “What’s the worst that could happen?” is in the world of earnings estimates.  We all use the consensus numbers, the simple average of every analyst that covers the stock in question.  The theory is simple enough, and based on the wisdom of crowds.  The more the merrier and one more non-correlated guess tends to make the average a better predictor over time. 

Take the 30 stocks of the Dow Jones Industrial Average, which on average trade for 14.8x next year’s consensus numbers. 

The lowest individual P/E ratios belong to financial names (Goldman Sachs at 8.7x, JP Morgan at 9.5x) and technology (IBM at 9.0x). The highest multiples go to Nike (25.3x), Visa (23.2x) and Coca-Cola (18.9x).  Everything else is in between these high and low points.

Now, ask that worst-case scenario question…  What if the most bearish Wall Street analyst number is actually right?  We’ve included those in the table as well.  The average P/E based on that lowest earnings estimate for 2016 is 16.7x.  Sounds pretty “Cheap” when you consider where the 10 year Treasury is trading, at 2.1% as of the close today.  Based on that calculus, it would be easy to say “Stocks are cheap based on the Street’s worst case scenario”.

Not so fast.  Here’s the problem: stocks probably should trade at roughly 17x earnings, and the Street knows that. There aren’t actually any nickels in front of the steamroller when you look at the world this way. The Dow is at 16,000 because the market believes the “Worst case scenario” is actually the best guess at a base case outcome.

Why the pessimism?  It comes down to revenue growth expectations.  Along with those worst-case earnings estimates, we also pulled what the Street’s analysts are publishing for sales estimates in 2016. The consensus calls for 3.7% top line growth. The worst case (the one underpinning that 16.7x multiple) is for an average 1.7% decline in revenues from this year.  That would make for a 1.5% decline in the Street’s worst case scenario for earnings in 2016 versus 2015. 

It is worth mentioning that the worst case scenario for corporate earnings in 2016 isn’t really all that dire. For the 30 companies of the Dow, the difference between the consensus for next year and the lowest estimate is just 10.2%.  We did this math a few years ago, and that number was essentially the same.  Analysts express caution on earnings in relatively small steps.  Granted, for the energy names (ExxonMobil and Chevron) the spread does widen out to a 56-72% ratio of worst case to consensus.  For Apple, the most widely followed name in the Dow, the difference is only 16%. 

Still, the difference between consensus and worst case is stark enough: the former calls for revenue and earnings growth while the latter sees declines. With that paradigm in hand, we have enough to draw some conclusions:

Markets need some reassurance on revenue growth, and they need it now.  The problem with a negative growth scenario is that investors can imagine further deterioration from the 1.7% decline already imbedded in stock prices.  What you focus on expands, as the saying goes.

 

 

They probably aren’t going to hear much of that on Q3 earnings conference calls.  Put yourself in the shoes of the typical CEO or CFO just now.  Their stocks are down on the year, in many cases by double digits. They’ve just seen a quick flush for the market as whole, followed by a retest just this week. This is not an environment that breeds brave talk. At the point they are better off guiding down, letting the stock settle out, and outperforming financial guidance in 2016.

 

Past earnings season, a lot is riding on current economic data, news from the Chinese economy, and crude oil prices. The market’s mood on all three points is still decidedly soggy.  Perversely, that’s probably the most upbeat point we can make in this note. If the news flow from either the macroeconomic front or corporate earnings guidance is even a bit chirpy, the market may back away from its fixation with the worst case scenario.