Sunday, April 8, 2018

Equities: Nick Colas Has Three Downside Scenarios

Readers may remember Mr. Colas from his Morninig Market Briefing at  Convergex Group. After Cowen bought Convergex he co-founded DataTrek Research.

From MarketWatch (recently readmitted to the blogroll at right) April 6, 5:04 pm EDT:

Why stocks could fall nearly 40% over the coming 18 months 
Considering the potential bottom in three types of market decline
The U.S. stock market has seen extreme volatility over the past two months, as investors grapple with the prospect of a trade war, potential regulation for large-capitalization internet companies, and changing monetary policy from the Federal Reserve.

No doubt, many investors are wondering how bad things could get, and how far the market could reasonably fall. According to one analyst, the level where the S&P 500 SPX, -2.19%  could bottom depends on what kind of selloff Wall Street sees. But in any of three potential paths, more pain can be expected ahead.

Nicholas Colas, co-founder of DataTrek Research, offered three downward scenarios that the equity market could take: a sudden crash, akin to October 1987, where stocks drop sharply over a short period; a “slow motion train wreck” where the time until the bottom is longer but daily losses along the way are shallower; and a “catalyst-driven price reset,” as investors fret that a recession could be on the way, even if one doesn’t materialize.

Colas emphasized that “we are not expecting a U.S. equity market crash or even a snarly bear market,” but admitted, “There’s no sense in denying the obvious—U. S. equity markets feel shaky.”

The first scenario, an abrupt crash, may sound worse than it would end up being, he wrote in a research report. He noted that after 1987’s Black Monday—still the single-largest one-day percentage drop for the Dow Jones Industrial Average DJIA, -2.34% ever—stocks still closed higher for the year, and ended up nearly 10% from the low of that crash.

Colas used Black Monday as a guide, calculating that at the close of trading on that day, the S&P 500 had a forward price-to-earnings ratio of 9.3 while the U.S. 10-year Treasury note TMUBMUSD10Y, -1.97%  yielded 8.9%. He added the P/E to the yield, for a total of 18.2, which he said could be used as a proxy for measuring the valuation of the two markets. Currently, the 10-year yields around 2.80%, so to reach the same combined valuation, the S&P’s P/E would have to drop from its current level of about 16 down to 15.4.

In order for the S&P to reach that P/E, the benchmark index would have to fall to 2,187, which Colas dubbed a “1987-style low.” Based on Friday’s close, that hypothetical bottom would represent a drop of 16%, and a drop of nearly 24% from the S&P’s record high, which would be enough to put the S&P into bear-market territory. “Not great, but hardly awful either,” Colas wrote—particularly compared with the other prospects....MUCH MORE
The P/E + treasury yield is a facile way to introduce a rule of thumb that is somewhat akin to the 'Rule of 20' which says the inflation rate + the market P/E should sum to 20 or less as a quick-n-dirty fair value approximation.
It is shorthand and not gospel.

Here's how the "Rule" performed vs reality:
Close enough to give you a feel for where things stand but definitely not something to bet the rent money on.
That said, the divergences in 1980-1982 and 1998-2000 might have given some advance warning of the respective up and down moves in the broader market prices.

Chart from Capital Investment Services.