The Relationship Between S&P 500 P/E Ratios and US Interest Rates

Download the white paper here.

As a follow up to our more comprehensive 2017 paper and 2018 paper, this paper will strictly focus on the historical and current relationship between the S&P 500 P/E Ratio and US Interest Rates, updated to November 2022.

The P/E ratio can be described as the ratio between current share price and per-share earnings.  Earnings in the S&P 500 are calculated using the 12-month earnings per share of “current” earnings.  A higher P/E ratio suggests that investors expect higher earnings growth in the future.

During the period January 1971 to November 2022, the S&P 500 P/E ratio averaged 19.9x, while the median S&P 500 P/E ratio was 18.3x.[1]  The S&P 500 P/E ratio as of November 16, 2022 was 20.6x, which is slightly higher than the historical average of 19.9x.[2]  This ratio is currently in the 62nd percentile of the historical distribution.

The Relationship Between S&Amp;P 500 P/E Ratios And Us Interest Rates

The Relationship Between S&Amp;P 500 P/E Ratios And Us Interest Rates

It is important to understand that returns can be estimated as changes in the P/E ratio and changes in earnings; therefore, factors that drive changes in the P/E ratio will also drive stock returns.

P/E ratios have demonstrated an inverse relationship to interest rates.  Given recent interest rate hikes and expectations for the Federal Reserve to continue to increase rates, at least in the short-term, P/E ratios are likely to decline.

However, only 22.4% of the variability in P/E ratios can be explained by the regression with interest rates, where interest rates (i) are the independent variable and P/E ratios are the dependent variable.

When we test the current federal funds rate of 3.83%, our equation predicts an S&P 500 P/E ratio of 21.5x – very close to the current P/E ratio.

The Relationship Between S&Amp;P 500 P/E Ratios And Us Interest Rates

The Relationship Between S&Amp;P 500 P/E Ratios And Us Interest Rates

[1]      Based on monthly data from multpl.com.

[2]      July 2022 through November 2022 P/E ratios are estimates.

For more information, contact:

Marty Hanan is the founder and President of ValueScope, Inc., a valuation and financial advisory firm that specializes in valuing assets and businesses and in helping business owners in business transactions and estate planning.  Mr. Hanan is a Chartered Financial Analyst and has a B.S. Electrical Engineering from the University of Illinois and an MBA from Loyola University of Chicago.

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Transcending Value – Liquidation, Monetary, Financial, and Strategic Value

Blog 2 of 4: 

This is the second in a series of blogs that attempts to explain and distinguish between various valuation concepts, such as price, fair market value, fair value, liquidation value, intrinsic value, financial value versus strategic value, monetary versus economic value, emotional and psychic value, among others. Environmental, social, and governance (ESG) value is relatively new, and gaining acceptance in corporate America.  Hedonic value has various meanings and uses but is usually thought of as the immediate, emotional gratification (perhaps a cause for impulse buying), as contrasted to utilitarian value.

Many people have heard of the cost, market, and income approaches to valuation, and these various approaches and hybrids can sometimes be applied to determining the different value standards mentioned above.  But while valuation (the process of putting a value on something) is part science and part art, there are well accepted techniques, methodologies, and theories that should be adhered to. Valuation necessarily requires an understanding and deep insight into accounting, economics, and finance.  Now, statistical analysis, behavioral finance, and cultural economics are playing a more frequent role in valuation.

Liquidation, Monetary, Financial, and Strategic Value

The liquation value is simply the FMV without the intangible assets of the business unless certain intangibles such as patents can be separately sold/licensed and utilized by another firm.  The monetary value is just what it says, pure cash value without regard to any psychic benefits.

To the typical private equity group (“PEG”), financial value rules – buy low and sell high.  It is all about cash-on-cash return.  A PEG usually requires higher returns (in part, to compensate for additional perceived risk since a seller will always know more than a buyer); therefore, the financial value is less than the expected monetary value (until they are a seller, of course).  PEG buyers also often look for market inefficiencies to achieve superior returns.  More often private equity buyers compete with strategic buyers (most often corporate buyers) in that revenue and cost savings synergies accelerate their value creation.

Transcending Value - Liquidation, Monetary, Financial, And Strategic Value

For the complete white paper go to: https://lnkd.in/gtPdGNf

For more information, contact:

Marty Hanan is the founder and President of ValueScope, Inc., a valuation and financial advisory firm that specializes in valuing assets and businesses and in helping business owners in business transactions and estate planning.  Mr. Hanan is a Chartered Financial Analyst and has a B.S. Electrical Engineering from the University of Illinois and an MBA from Loyola University of Chicago.

If you liked this blog you may enjoy reading some of our other blogs here.

Transcending Value – Intrinsic and Fair Value

Transcending Value – Intrinsic and Fair Value

Blog 1 of 4: 

This is the first in a series of blogs that attempts to explain and distinguish between various valuation concepts, such as price, fair market value, fair value, liquidation value, intrinsic value, financial value versus strategic value, monetary versus economic value, emotional and psychic value, among others. Environmental, social, and governance (ESG) value is relatively new, and gaining acceptance in corporate America.  Hedonic value has various meanings and uses but is usually thought of as the immediate, emotional gratification (perhaps a cause for impulse buying), as contrasted to utilitarian value.

Many people have heard of the cost, market, and income approaches to valuation, and these various approaches and hybrids can sometimes be applied to determining the different value standards mentioned above.  But while valuation (the process of putting a value on something) is part science and part art, there are well accepted techniques, methodologies, and theories that should be adhered to. Valuation necessarily requires an understanding and deep insight into accounting, economics, and finance.  Now, statistical analysis, behavioral finance, and cultural economics are playing a more frequent role in valuation.

Transcending Value – Intrinsic and Fair Value

Intrinsic value can be related to psychic or emotional value but normally is thought of as the cash equivalent value (on a present value basis) to a specific owner.  That owner is usually the current owner and the value usually represents the value of the future cash flow, including the proceeds from a future sale.  Since taxes can be quite different in a sale (capital gains) versus income, normally an after-tax analysis is required to understand the scenario that may be more advantageous; hold versus sell.  But, once again, the owner may derive “satisfaction” and other rewards from being the owner/boss.  The tradeoff may be more than money, especially since the owner is incurring more risk.

I have placed the intrinsic value bubble above and to the right of FMV since the owner may have more time value (can realize income for more years and sell at a later date), all the while deriving more emotional or psychic benefits.

Fair value, like intrinsic value can certainly overlay (in the range of possible values) FMV and is normally calculated without regard to discounts associated with the lack of control and marketability.  The fair value of public stock is normally the same as its FMV.  In the case of closely held companies, the two can be markedly different because minority shareholders in private companies usually cannot sell their stock easily or control operations.

Transcending Value - Intrinsic And Fair Value

For the complete white paper go to: https://lnkd.in/gtPdGNf

For more information, contact:

Marty Hanan is the founder and President of ValueScope, Inc., a valuation and financial advisory firm that specializes in valuing assets and businesses and in helping business owners in business transactions and estate planning.  Mr. Hanan is a Chartered Financial Analyst and has a B.S. Electrical Engineering from the University of Illinois and an MBA from Loyola University of Chicago.

If you liked this blog you may enjoy reading some of our other blogs here.

Middle Market Private Equity M&A Activity – Q1 2020

Click to Download:  Middle Market Private Equity M&A Activity – Q1 2020 Market Valuations Shift

Executive Summary

Valuations Heightened

The simple average Enterprise Value (EV) to EBITDA multiple of 7.4x for Q1 2020 was marginally higher than the previous four quarters. This was the net result of a shift in sentiment considering size and industry factors.

Size Premium

Size became an even greater pricing consideration for the middle market as transaction multiple variances widened for acquisition targets above and below $50 million.

Continued Use of Leverage

Total debt to EBITDA remained at 3.9x from 2019. Senior debt to EBITDA rose steadily to 3.5x, up from 3.2x and 3.0x in 4Q and 3Q 2019, respectively.

Distribution Takes the Top

Transaction multiples for the distribution industry sharply rose above the health care services and technology industries for the first time over the past five years.

Based on our review of GF Data’s latest M&A Report, the reported results for Q1 2020 display a slight increase in transaction multiples, contrary to previous, first-quarter declines.  Although enterprise value (EV) to EBITDA multiples rose to 7.4x, an increase of 0.3x from Q4 2019, material shifts occurred between company size and industries as a result of the COVID-19 pandemic. The total number of reported Q1 2020 transactions remained normal at 62. Most of these transactions took place in the first two months of the quarter before business conditions weakened in early March.

Middle Market Private Equity M&Amp;A Activity - Q1 2020

Average EV/EBITDA transaction multiples increased for the larger companies in the $50 – 250 million enterprise value range and decreased for the smaller companies in the $10 – 50 million range. The increased market uncertainty likely caused a premium to be paid for the larger and perceived safer, companies.

Industry Analysis

We analyzed industry average EV/EBITDA multiples of acquisition targets to gain a more in-depth understanding of how the market perceived industry risk and growth prospects as COVID-19 began to disrupt the marketplace during the first quarter. Approximately 80% of the reported deal volume comprises four industries: manufacturing, business services, health services, and distribution.

Middle Market Private Equity M&Amp;A Activity - Q1 2020

The average EV/EBITDA transaction multiple for health care services experienced a steep decline to 7.4x in Q1 2020, down from 8.4x in 2019. The health care services industry has been negatively impacted in the short-run by the COVID-19 pandemic, as both practices and patients avoided preventative check-ups and elective treatments.  On the contrary, the distribution industry average EV/EBITDA multiple increased markedly to surpass all other recorded industries. The distribution industry was valued extremely high in the first quarter as consumer e-commerce presence and demand for deliver-to-door goods grew considerably. Manufacturing and business services transaction multiples remained approximately the same over the last few years. The technology industry experienced a dip in its average EV/EBITDA valuation multiple to its lowest level since 2016. There was no recorded Q1 2020 transaction data for the retail and media telecom industries.

For more information, contact:

Middle Market Private Equity M&Amp;A Activity - Q1 2020

Michael Hanan

ASSOCIATE
Full Bio →

 

The information presented here is not nor should it be treated as investment, financial, or tax advice and is not intended to be used to make investment decisions.

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Illiquid vs. Insolvent – Understanding the Difference

Click to Download:  Illiquid vs. Insolvent: Understanding the Difference

Executive Summary

The Issue:

Companies are facing cash shortfalls as they struggle to reopen from the COVID-19 lockdown.  Companies facing short-term liquidity challenges can seek new cash sources, such as the government’s Payroll Protection Program “PPP” or a bank line-of-credit.  However, certain companies may never achieve the revenue and profitability necessary to remain viable as a going-concern and may ultimately be forced into bankruptcy.  Understanding whether your company faces a liquidity or solvency issue will allow you to most efficiently utilize your available resources.

Illiquid vs. Insolvent

Operating models of illiquid companies may be viable in the long-term, but cash issues could arise in the near-term due to poor cash management or an exogenous shock to the company’s operating performance.  Insolvent companies, on the other hand, have an unsustainable operating model to support operating and debt obligations over the long-term.

What Needs to be Done?

A complete understanding of the company’s financial obligations and operating outlook is necessary to understand whether the company is experiencing a liquidity or solvency issue.  Companies which are publicly traded or have bank debt may require solvency opinions to be performed.  ValueScope’s team of experienced financial analysts and consultants can help you understand what your options are to get through this difficult time.

Our team of professionals provides:

    • Experience- we’ve conducted solvency and liquidity analyses for clients across the country
    • Credibility- Ph.D.’s, CFA’s, CPA’s, ASA’s, CVA’s, and MBA’s
    • Independence- we have the personnel, expertise and research resources to provide the assurance you require for a solvency opinion

The Issue at Hand

As businesses have been unable to fully function because of the COVID-19 pandemic, governments have stepped in to provide stimulus packages to equip them with the resources to survive the short-term.  In the United States, the Payroll Protection Program (“PPP”) was set up to provide small businesses with a direct financial incentive to keep their workers on the payroll [1].  Yet the PPP, or any realistic government program, can only solve a business’s short-term liquidity issues.  When a business’s operating performance struggles for a prolonged period of time, and their short and long-term cash inflows are no longer able to meet their financial obligations, the company could become insolvent.

Understanding a Liquidity Issue

A company’s liquidity is a measure of its ability to meet its near-term financial obligations.  Companies can be profitable with positive cash flow and experience liquidity issues.

As an example, assume ABC Company has the following cash flow statement:

Illiquid Vs. Insolvent - Understanding The Difference

As the cash flow statement indicates, ABC Company has positive monthly net income of $100, and sufficient cash flow to cover their necessary capital expenditures and debt repayment obligations.  As a result, the net monthly cash flow is positive $50.  However, a profitable company can still experience a short-term liquidity issue.

As mentioned above, liquidity issues arise when a company cannot meet their near-term financial obligations.  Imagine that ABC Company has the following balance sheet:

Illiquid Vs. Insolvent - Understanding The Difference

Companies experiencing a liquidity problem often face a disconnect between their current assets and current liabilities.  As the ABC Company balance sheet indicates, the company’s current ratio is below 1.0, meaning current liabilities exceed current assets [2, 3].

Additionally, assume $50 of the salaries payable are due today and $25 of the short-term debt is due tomorrow.  Currently ABC Company’s cash on hand is insufficient to meet these needs.  ABC Company is now unable to meet their debt obligations and could be forced into bankruptcy if they cannot meet their obligations.

Dealing with Liquidity Issues

Fortunately, liquidity issues can be resolved in the short-term through obtaining additional financing, such as a line of credit, and in the long-term through better cash flow management.  Improved cash flow management could include negotiating better terms on a company’s AR and AP, and better managing inventory levels.

The PPP is designed to keep companies from experiencing liquidity issues by providing them with the cash necessary to pay their day-to-day expenses and keep them from experiencing a liquidity issue.  However, the PPP is not indefinite, in which case businesses which struggle to regain their customers could ultimately experience a solvency issue.

Understanding When Illiquid Becomes Insolvent

While there are numerous operational and financial options for companies experiencing illiquidity issues, companies experiencing insolvency have far fewer options.  Insolvency includes illiquidity, but without realistic financing options and immediate operational opportunities for improvement.

As an example, assume that XYZ Company has the following cash flow statement:

Illiquid Vs. Insolvent - Understanding The Difference

Unlike our illiquid company, XYZ Company’s monthly cash flow is not sufficient to cover their debt repayment obligations.  Even if they were to cut their capital expenditures to $0, XYZ Company would not generate sufficient cash flow to service their debt.  In this scenario, any short-term financing or accounts receivable improvement would only provide a temporary solution.

Additionally, imagine the XYZ Company has the following balance sheet:

Illiquid Vs. Insolvent - Understanding The Difference

In addition to having cash flow issues, XYZ Company also has total liabilities which exceed total assets.  Between their short-term and long-term debt, XYZ Company has total debt of $850.  Even if XYZ Company sold all of their assets at book value, they would not be able to cover their debt obligations.

Dealing with Insolvency

Companies facing insolvency do not generate the income and cash flow necessary to support their operational and debt obligations.  These companies must identify opportunities to increase net income and cash flow from operations, either through increasing revenue or decreasing expenses.  If the company is unable to improve their operations, their debt burden will be too great, and the company will eventually be forced into bankruptcy.

ValueScope Can Assist You

Companies facing liquidity and solvency issues face tremendous challenges.  Whether it is dealing with creditors, requiring solvency opinions, or working to improve cash flow management, ValueScope’s team of financial and valuation consultants can assist you and help get you through this difficult time.

[1] Loans made through the PPP will be forgiven if all employees are kept on staff for the next eight weeks and the money is used for payroll, rent, mortgage interest, and utilities. (Source: https://www.sba.gov/funding-programs/loans/coronavirus-relief-options/paycheck-protection-program-ppp)

[2]  Current Ratio = Current Assets / Current Liabilities.  The current ratio is the most basic liquidity test. It signifies a company’s ability to meet its short-term liabilities with its short-term assets. A current ratio greater than or equal to one indicates that current assets should be able to satisfy near-term obligations. A current ratio of less than one may mean the firm has liquidity issues. (Source: Morningstar).

[3] Evaluating a “good” current ratio requires a review of the business model, industry averages, and historical performance.

[4]  Currently the PPP funds must be spent in the first eight weeks for the loan to be forgiven.

For more information, contact:

Illiquid Vs. Insolvent - Understanding The Difference

Benjamin Westcott, CFA

MANAGER
Full Bio →

The information presented here is not nor should it be treated as investment, financial, or tax advice and is not intended to be used to make investment decisions.

If you liked this blog you may enjoy reading some of our other blogs here.

ValueScope Launches Houston Office With Principal Thomas J. McNulty

Click to Download:  ValueScope Launches Houston Office With Principal Thomas J. McNulty

ValueScope, Inc. is excited to announce that Tom McNulty joined the firm on April 27, 2020 as a Principal and Managing Director who will launch our Houston Office.  Tom’s responsibilities include financial consulting, valuation analysis, transaction and dispute advisory, and expert testimony.  In addition to serving as the Managing Director of the Houston office, Tom will assume the position of Energy Practice Leader.

Tom McNulty has 25 years of experience working across numerous industries as well as the entire energy value chain.  He draws on a rare combination of industry, banking, consulting, and government experience to provide his clients with transaction, financial advisory, litigation, and valuation opinion services.  Tom is a nationally recognized energy industry expert and is a frequent contributor on CNBC, Fox Business, and Bloomberg TV.  In addition to his deep knowledge and experience in the energy industry, Tom is well respected for his expertise in derivatives pricing and valuation.

As an advisor, and in his corporate career, Tom has delivered more than $52 billion in transaction, valuation, restructuring, and litigation projects, much of which is energy related.  He has also advised on, or executed, $13 billion in M&A and principal investment deals, and executed or valued more than $14 billion notional in derivative instruments.  His expert litigation work has included shareholder disputes, business valuation, derivatives and hedging, bankruptcy and restructuring matters, and economic damages assessments. 

Tom holds the prestigious CQF (Certificate of Quantitative Finance) and FRM (Financial Risk Management) designations and received his BA from Yale University and MBA from Northwestern’s Kellogg School with various honors.

Tom can be reached at tmcnulty@valuescopeinc.com and at 832-472-3717.

The COVID-19 Market Decline: Now May Be the Best Time to Gift

Click to Download:  THE COVID-19 MARKET DECLINE:

NOW MAY BE THE BEST TIME TO GIFT

It has certainly been a rough couple of weeks with the recent fall off in the stock market and the shutdown of many businesses, but there may be a silver lining for people who intend to gift in the near future.  The recent decline in market valuations provides an opportunity to gift at lower values, potentially allowing you to gift assets using your lifetime exemption that would have otherwise resulted in a taxable event before the decline.  Given the additional uncertainty surrounding the Presidential Election and what might happen to the estate and gift tax exemption level, now may be the best time to do some gifting.

The U.S. Stock Market Value Over the Last Five Years

From March 23, 2015 through February 19, 2020, the S&P 500 increased from 2104.42 to 3386.15, a 60.9% return excluding dividends.  Between February 19, 2020 and March 19, 2020, the market decreased by 28.85% to a value of 2409.39.  The market decline over the last month decreased the total return over the five-year period ending February 19, 2020 to just 14.5%.  The chart below shows the S&P 500’s value over the five-year period ending March 19, 2020.

The Covid-19 Market Decline: Now May Be The Best Time To Gift

Looking at the performance of the stock market this year, we see a decline of 25.4% year-to-date through March 19, 2020.  However, the year did not start that way.  From December 31, 2019 to February 19, 2020, the S&P 500 increased from 3230.78 to 3386.15, a gain of 4.81%.  The index then fell to 2409.39 as of March 19, 2020, a decline of 28.85%.  The chart below shows the S&P 500’s value year-to-date through March 19, 2020.

The Covid-19 Market Decline: Now May Be The Best Time To Gift

Enterprise Value to EBITDA (EV/EBITDA) Multiples Over the Last Five Years

From March 23, 2015 through February 20, 2020, the Enterprise Value (EV) to EBITDA multiple for the S&P 500 increased from 10.60x to 14.73x, an increase of 38.96%.  Between February 20, 2020 and March 19, 2020, the EV/EBITDA multiple decreased by 25.19% to a value of 11.02x (only 3.96% above the value five years earlier).  The following chart shows the S&P 500’s EV/EBITDA multiple over the five-year period ending March 19, 2020.

The Covid-19 Market Decline: Now May Be The Best Time To Gift

The EV/EBITDA multiple at the end of last year was 14.06x, which was in the 97th percentile of the EV/EBITDA multiple distribution over the last five years.  The recent value of 11.02x on March 19, 2020 is below the 25th percentile.  The chart below shows the distribution of the S&P 500’s EV/EBITDA multiple over the five years ending March 19, 2020.

The Covid-19 Market Decline: Now May Be The Best Time To Gift

Appendix A (download the paper to view Appendices) contains the major valuation multiples for the S&P 500 and its industry sectors as of December 31, 2019.  Additionally, it shows the rank of the industry sectors based on each valuation multiple.  Appendix B contains the same information as of March 19, 2020. 

Appendix C shows the percentage change in the valuation multiples from December 31, 2019 to March 19, 2020 as well as the rank of the industry sectors based on largest decline in each valuation multiple.  As one would expect, the Energy Sector had the largest decline in all multiples, except for price to earnings (P/E), where the Energy Sector actually had an increase.  The Financials Sector saw the next largest decline in valuation.  The Utilities and Consumer Staples Sectors saw the smallest declines in valuation, which is expected given they are both defensive industries.  That said, both industries still saw significant declines in valuation.

Conclusion

The significant recent declines in valuation multiples provides an opportunity to execute gifting at lower values that could have been done previously.  Given the additional uncertainty surrounding the Presidential Election and what will happen to the estate and gift tax exemption level following the election, it may very well be an opportune time to gift.

[1]  A 10.2% annualized return over the 4.9-year period.

[2]  A 2.7% annualized return over the 5.0-year period.

[3] While the S&P 500 reached a high on February 19, 2020, the EV/EBITDA multiple reached a high on February 20, 2020.

[4]  Earnings before interest, taxes, depreciation, and amortization or EBITDA is a measure of earnings (profitability) of a company and is frequently used as a proxy for operating cash flow.

[5]  The daily EV/EBITDA multiples were obtained from S&P CapitalIQ.  CapitalIQ aggregates the multiples of the index constituents, using a weighting based upon market cap or enterprise value.

For more information, contact:

The Covid-19 Market Decline: Now May Be The Best Time To Gift

Michael Conroy, CFA

DIRECTOR
mconroy@valuescopeinc.com

Mr. Conroy has more than 20 years of consulting and business valuation experience, concentrating on complex estate and gift valuation matters. He provides business valuation and financial consulting services to companies in a broad range of industries. Working with domestic and international clients, Mr. Conroy has performed thousands of business appraisals involving gift and estate tax, financial reporting, mergers, and acquisitions (valuations for buyers/sellers, fairness, and solvency opinions), litigation support, expert testimony, and other company requirements (including stock options and ESOPs). Mr. Conroy previously worked with the national valuation firm CBIZ Valuation Group, LLC here he was a senior manager. Prior to that, he taught chemistry and physics to high school and college students at Xavier College in Ba, Fiji, for two years as a U.S. Peace Corps volunteer.

The Covid-19 Market Decline: Now May Be The Best Time To Gift

Jason Wainwright, CFA, ABD

SENIOR MANAGER
jwainwright@valuescopeinc.com

Mr. Wainwright is a Senior Manager at ValueScope Inc., Inc. In this position, he has worked on and managed numerous business valuations and projects for firms spanning multiple industries, including energy, defense, consumer products, professional services, and healthcare. Mr. Wainwright is a CFA charterholder, has a BBA in Finance & Economics from Texas Wesleyan University, and a MS in Quantitative Finance from the University of Texas at Arlington. Additionally, Mr. Wainwright completed all of the course work and the written and oral comprehensive examinations toward a Ph.D. in Finance from the University of Texas at Arlington.

 

The information presented here is not nor should it be treated as investment, financial, or tax advice and is not intended to be used to make investment decisions.

If you liked this blog you may enjoy reading some of our other blogs here.

Valuation During a Pandemic

Valuation During a Pandemic: How to Approach Covid-19 When Investing in Common Stocks

In financial markets, infrequent or rare events are referred to as “Black Swan” events.  The term “Black Swan” was popularized by Nassim Nicholas Taleb in his 2007 book, The Black Swan:  The Impact of the Highly Improbable.  Taleb describes Black Swan events as possessing three key attributes:

  1. Extremely rare
  2. Severe impact
  3. Obvious in hindsight

Such events can have fundamental causes such as the 2008 market decline and recession or simply can be the result of herd events where people rush to reset expectations.  Regardless of the cause, the US stock market and securities markets in general have proven to be surprisingly resilient since World War II.

The chart below depicts the S&P 500’s value from September 12, 2008 (the trading day before Lehman Brothers declared bankruptcy) through December 21, 2010.  On September 12, 2008, the index closed at 1251.70.  Over the following six months, the S&P 500 fell 46.0% to 676.53.  The market recovered over the following 21 months, reaching 1254.60 on December 21, 2010.

Valuation During A Pandemic

Similar to the 2008 crash, the coronavirus, or Covid-19, typifies a Black Swan event.  Due to the high incidence of severe cases and lack of sufficient hospital and emergency facilities to handle the pandemic if left unchecked, suppression strategies to slow the spread and peak number of cases requiring hospitalization are being adopted [1].   These suppressions strategies include:

  • Self-quarantine for persons exposed to persons with the virus;
  • Closing schools for periods of time;
  • Limiting the size of group meetings;
  • Restricting or closing many retail businesses;
  • Limiting food service to drive-through or take-out;
  • Limiting travel (banning some international destinations and persons originating from certain places) and screening passengers departing and arriving on planes and ships
  • Banning unnecessary travel outside the US (e.g., to parts of Italy and China).

Obviously, such suppression strategies will have economic consequences that will suppress or depress economic activity in many business sectors but could reward others.  Additionally, the greater the uncertainty as to how long, how severe, and how permanent the damage, the greater will be the valuation consequences.

The following chart provides a comparison of the stock market during the 2008 crash following the Lehman Brothers bankruptcy and the Covid-19 crash that we are currently experiencing.  We have indexed the starting values to 100 to provide a better comparison.  March 17, 2020 was the 19th trading day of the Covid-19 crash.  Since the high of 3386.15 on February 19, 2020, the market has declined 25.3% to close at 2529.19 on March 17th.

Valuation During A Pandemic

As shown in the chart above, the trajectory of the Covid-19 crash is similar to that of the 2008 crash.  By day 19 of the 2008 crash, the market had lost 27.3%, declining from 1251.70 to 909.92.  The key question is:  How will Covid-19 actual impact valuations moving forward?  This paper seeks to provide a framework for answering that question.

Market Valuation:  The Two Key Factors

Fundamentally, all valuations should be based on two factors: 1) expectations of the amount and timing of future cash flows and 2) the perceived “systematic” risks associated with such cash flows.  It follows then that changes in valuations result from changes in these two factors.  John Campbell and Tuomo Vuolteenah describe the sources of market crashes as:

”The value of the market portfolio may fall because investors receive bad news about future cash flows; but it may also fall because investors increase the discount rate or cost of capital that they apply to these cash flows.” [2]

Factor 1:  Expectations Regarding the Amount and Timing of Cash Flows

For most businesses, especially those in hospitality (e.g., restaurants, hotels/motels), entertainment (e.g., sporting events), and travel (e.g., airlines), there will be an extended period where business will be depressed (even without government mandates or restrictions) or entirely shut down.  Some estimates project extremely depressed activity levels in the United States could be as short as mid-May or at least until August 2020.  Additionally, it may be that periodic shutdowns in specific communities, regions of the world, or countries may occur until there is confidence that anti-viral regimens have proven successful in limiting and treating the illness and become more widely available, vaccines are at least safe and partially effective and more widely available, and/or the capacity of the health care facilities and systems to treat the severe cases is manageable.   That may mean that we cannot expect a complete resumption of previous levels of travel and commerce in some business sectors until as late as mid-2021 but we might observe partial recoveries in at least some activities over time.

For the most adversely affected businesses, there will be questions regarding the extent of the losses and the ability to sustain them.  Business which requires travel, larger groups, or social interaction are likely to suffer the greatest losses.  At this point in time, at least until the next set of quarterly earnings, conference calls, and revised guidance, the extent of the losses will be uncertain even within defined periods of time, and the length of time those losses will occur will still remain highly uncertain.  This explains in large part the high volatility (i.e., large fluctuations) in the US stock exchange indices over the past two weeks.

Resiliance

 Resilience relates to the ability of businesses to withstand periods of depressed economic activity.  Resilience is affected by a company’s degree of operating leverage and financial leverage.  Operating leverage is affected by the fixed costs and expenses a business must incur to remain either minimally open (if remaining open but with reduced economic activity) or to prevent a loss of the value of assets or foreclosure (e.g., rents, maintenance, storage costs, minimum salaries of retained personnel).  Financial leverage is a function of the amount of liquid assets (cash and investments, which reduce leverage) a business has and the amount of liabilities, especially interest-bearing debts, a business must honor, and the rate of payments required to avoid a default, foreclosure, or bankruptcy. [3]

Mitigation

Mitigation is related in part to the degree to which government subsidies or supports may be received, creditors may extend credit or defer required payments, and the extent to which the company will be able to raise additional funds, if needed, in order to avoid failure and soften the losses.  Government support is likely only in key business sectors, is uncertain as to amount and types (more likely in the form of loans which will have to be repaid once the economy recovers) and will likely vary by country and business sector.  US airlines, for example recently estimated losses of at least $58 billion and appear to be hopeful that at least some types of favorable loans might be provided for relief, but no specific indication exists as to the extent or type of mitigation.  Many creditors of businesses suffering short-term losses or distress may be willing to defer or reduce required or past-due payment amounts on liabilities in order to prevent any otherwise viable business from being forced into bankruptcy.

Cash Flow Expectations and Valuation

To simplify the problem of valuing a common stock, it might be possible to think in terms of the cash flow from now through the end of the crisis, the price at the end of the crisis,  and the probability that the business survives the crisis.  In this framework, the value of a common stock would be as follows:

Valuation During A Pandemic

where:

P0   =    the current price of the security

psurvive  = probability that the business will survive until the end of the crisis

CF =    the “cash” earnings or net cash flow per share between now and the end of the crisis

P1   =    the price of the security at the end of the crisis

r     =    the required rate of return over the crisis period which is the function of the long-term market risk-free interest rate and risk premium required for the given stock

In an even more simple way to proceed, think of CF as the amount of dividends you expect through the end of the crisis.  For many companies that do not pay dividends, the amount expected is zero. [4]  Given that, the only question is determining psurvive, P1, and r.

The reason why the stock market indices are so volatile (and implied volatilities used to value stock options are so high) is because investors have different and rapidly changing views about the cash flows during the crisis, the probability of survival, the value at the end of the crisis, and the required rate of return for each company that is publicly traded and for the market as a whole.  To the extent that many investors are looking at broad stock market indices and funds (ETFs or mutual funds), it is entirely likely that some common stocks will be inappropriately valued initially when panic selling occurs.

Some companies, like utilities and communications providers, may experience reduced revenues but have sufficient and sustained revenues (unless they have high debt loads) to remain minimally profitable during the interim period.  In that case, we might consider even a positive but reduced level of earnings in the short term with positive cash flow during the crisis and a probability of survival that would equal 100% or close to it.

Some grocery stores and pharmacies might actually be experiencing an increase in demand and sudden surge in revenues, but investors may be substantially overestimating the long-term effects.  Investors may be both overestimating the effects of cash flow increasing and implicitly assuming that the price after the crisis will increase as well when that may not be a reasonable assumption.  In other words, the sudden surge in buyers in grocery stores for certain products over the weekend may simply be temporary and once the one-time fears and sudden increases in demand have been fulfilled, revenues will revert to more traditional replacement level demand or may even decline later, to the extent only necessities are purchased by customers until the economic uncertainties are resolved.  This would mean that the short-term effects will be extremely modest or immaterial from a valuation standpoint.

Even when valuing a REIT (Real Estate Investment Trust), you may have to consider the extent to which certain properties derive a portion of their rents from the revenues of their larger tenants, experience increased vacancies, or have to decrease or defer rent payments from tenants until the economy recovers.  In that case, you might discount the amount of dividends that a REIT will pay or be able to pay from now until, say, June 30, 2020.

The oil and gas exploration and production industries are particularly interesting.  The availability of new methods of extraction and production have increased the estimated reserves available worldwide and lowered the costs.  Additionally, demand is affected by economic activity and, thus, expected to be depressed at least until sometime in 2021.  Finally, Russia and Saudi Arabia were unable to agree on reduced production levels, and Russia reportedly believes it can squeeze out the US producers that are heavily indebted to reduce the growth and amount of US production coming into the world market and depressing prices.  In that case, many US oil and gas producers may be facing substantial losses or declines in revenues, especially due to the extent they must drill, complete, and stimulate wells to continue to sustain production and/or are more heavily indebted.  Thus, for many US oil and gas producers, the probability of survival, will likely be significantly less than 100% and cash flow will certainly be negative for the company unless they own a lot of low-cost producing reserves.  Dividend payments will likely be suspended and the value remaining at June 30, 2021 (P1) may be reduced.

Factor 2: “Systematic” Risk and Uncertainty

Investors will naturally discount future values for the time it takes to realize those returns and for the underlying uncertainty.

“Systematic risk”

Most investors are considering a broad portfolio of investments.  They are not concerned with risks that are unique to a given company if those “company-specific” risks can be offset or can be substantially diluted by holding a diversified mix of common stocks.  Instead, they care more about “systematic” risk and especially “downside” risks that occur when the decline in value coincides with market-wide stock price declines and economic downturns.  For this reason, the discounts investors require do vary over time.  During periods of relatively stable economic activity and growth, the discounts for “systematic” risk tend to be reduced over time.  This is one reason the US stock market indices since 2010 have increased steadily and implied “risk premiums” over this period of time through say early February 2020 have generally declined.  However, in the current market conditions, with the belief that the US and world economy is in or will be in a severe recession in 2020, the “risk premium” has increased and is expected to increase substantially.  This means that the discount on the future value will be greater but even more importantly, sometimes investors apply the increased discount rate to the projected value of the stock and reduce the projected growth rates in the future for the economy and the business.  The simple “Gordon Growth” model is as follows:

Valuation During A Pandemic

where:

P0   =    the current price of the security

CF =    the steady-state level of “cash” earnings or net cash flow per share

g   =    the projected “normal” level of growth in earnings per share

r     =    the required rate of return which is the function of the long-term market risk-free interest rate and risk premium required for the given stock

Given the recent stock market declines, investors appear to be assuming generally that even when the economy recovers and stabilizes, CF may be lower in the future than now on a per share basis, g may be lower than previously expected, and the risk premium is greater due to uncertainty than it has been in the past. 

If, however, the economy stabilizes and recovers by June 2021, then the risk premium may revert back to normal and the stock market indices may entirely recover by June 2021 or at some point thereafter.  This may create a short-term investment opportunity at some point in 2020.  For example, Goldman Sachs on March 16, 2020 issued a general report indicating that it expected US stocks to potentially decline another 16% to a bottom around 2,000 on the S&P 500 Index from 2,386 at the close of trading on Monday, March 16, 2020.  The all-time high was reached on February 16, 2020, at 3,394.  Thus, by March 16, 2020, the S&P 500 Index (a broad US market index for common stocks) had fallen almost 30% from the high one month earlier.  If Goldman Sachs is correct, we could expect as much as a 41% decline from the highs realized earlier on February 16, 2020, in the next few months.

What is interesting, however, is Goldman Sachs is also predicting that the US stock market will recover most of the losses realized in the past month by the end of 2020.  Goldman Sachs projected the S&P 500 Index to be at 3,200 at year end under the scenario presented.  In other words, investors by the end of 2020 will have greater clarity and less uncertainty and assume that the economy and stock prices will entirely recover.  That would mean that share prices for larger US stocks would increase 26.5% from the close on Tuesday, March 17, 2020. 

Most investors are not making this assumption.  If they were assuming this to be true, then the S&P 500 Index would likely have recovered to at least 2,800 already.  It is more likely and assumed by most investors that at least some of the damage suffered in 2020 will be sustained and some companies will not recover from the economic effects by the even end of 2021. 

Uncertainty

Risks that are identifiable and understood tend to be managed and discounted in a normal and predictable manner.  Uncertainties that are more general and greater than normal, on the other hand, are not well managed or “priced” by investors.  Investors tend to overstate the “risks” in the face of uncertainty on average and, thus, tend to increase the risk premium in the expected return for investments more than they should and discount the longer-term average expected rate of return on such investments. 

Professor Damodaran, a corporate finance and valuation professor at the Stern School of Business at New York University, maintains an estimate of the equity risk premium. [5]  He estimated that the equity risk premium increased 55 basis points (0.55%) from February 1, 2020 to March 1, 2020, which only captures part of the market reaction to date. [6] In broad terms, that is more than a 10% increase in the equity risk premium in one month.  Also, long-term growth rates have declined in his estimates.  While approximate, this does give a good idea of the effects of uncertainty and suddenly negative news on how investors discount for risk and uncertainty.  By March 17, 2020, the implied equity risk premium increased by perhaps another 70 basis points (0.70%), which means that the equity risk premium increased by about 25% in one month due to uncertainty.     

Assuming the economy stabilizes and risk premiums revert to prior levels, this creates opportunities for investing against market sentiment.  For example, if an investor made a bet on the S&P 500 Index at the end of October 2008 (after the Lehman Brothers collapse but well before the market had bottomed out), and reinvested all dividends through March 17, 2020, the total return would have been 232.38%, or 11.1% per annum.    If an investor bet at the end of February 2009 (when the market was close to the bottom) and held until the end of January 2020 (close to the peak), then the total return would have been 450.5%, or 16.9% on an annualized basis. 

Obviously, it is not possible to “time” the market so perfectly, but the lesson from this example is that investors who hold on and don’t panic often come out with reasonable returns over longer investment horizons and holding periods. 

What the current stock prices in the US tell us is that investors may be over-reacting to short-term events that, assuming no systematic failures of the financial system occur, may provide unusual investment opportunities in the short-term. 

On the other hand, Goldman Sachs may be too optimistic in not accounting for the dilution in share values and debts that may be required to raise capital or borrow to cover losses in the short term in order to keep companies from failing and the risks of some companies failing.  At least some investors are betting on that happening.  Furthermore, if the US and world economy suffers more systematic damage to the institutions and faith in those institutions, a series of more serious consequences may follow, as occurred in the 1930s during the Great Depression.  The effects of the Great Depression were systematic in terms of failing financial institutions and the time required to recover.  Ultimately, a world war occurred, and it required a unique set of circumstances to pull the US economy out of the depression.  We highly doubt that will occur in this instance but cannot say that the risk is zero of at least some systemic damage occurring.  

Conclusion

We cannot predict what will occur and recognize tremendous uncertainty exists at this time as to the ultimate economic effects of the current pandemic.  But reacting and thinking logically helps to avoid panic selling into a downturn or overly enthusiastic buying in a booming market (which may have been the case by February 16, 2020).

[1]  See Walsh, “US, UK coronavirus strategies shifted following UK epidemiologists’ ominous report,” CNN, March 17, 2020.  Using simulation modeling, researchers estimated that “even if all patients were able to be treated, we predict there would still be in the order of 250,000 deaths in [Great Britain] and 1.1-1.2 million in the US.” Perhaps 15% of all persons infected will experience severe symptoms requiring treatment including oxygen and 5% of more will require critical treatment with ventilation, according to WHO.  Mortality estimates have been as high as 1% to 4% generally and are much greater for persons above the age of 60 or with known weaknesses in immune responses or adverse circulatory or respiratory conditions)

[2]  Campbell, J. Y., & Vuolteenaho, T. (2004). Bad Beta, Good Beta. The American Economic Review, 94(5), 1249–1275. Retrieved from http://www.jstor.org/stable/3592822

[3]  Financial distress can impose additional costs and cause even greater losses and, if severe, can inhibit a business from recovering once economic activity recovers.  See Hakala and Keath, “Analysis and Valuation of Distressed Equity Securities,” Valuation Strategies, September/October 1999, pp. 24-34.  Publisher: Warren, Gorham & Lamont.

[4]  Some companies will pay dividends over the interim period and possibly at a decreasing rate or amount as economic conditions deteriorate. 

[5]  Damodaran’s estimated equity risk premiums are updated on a monthly basis at:  http://pages.stern.nyu.edu/~adamodar/. 

[6]  The S&P 500 index decreased by 9.07% from February 3, 2020 to February 28, 2020 and decreased by an additional 18.16% from March 2, 2020 to March 17, 2020.

For more information, contact:

Dr. Scott Hakala has extensive practical knowledge of finance, economics, statistics, and business valuation theory. His expertise includes: corporate finance, restructuring and cost of capital; the valuation of securities and business interests (transactions, mergers, acquisitions, fairness opinions); the valuation of intangible assets (patents, trademarks); analysis of publicly traded securities (insider trading studies, trading analyses, event analyses, materiality, damages in securities litigation); expert testimony and economic loss analyses (commercial litigation); wage and compensation determination (reasonable compensation studies, lost personal income, wrongful termination); transfer pricing; derivative securities (options pricing and valuation); and antitrust and industry structure, strategic pricing, marketing and cost allocation analyses.

 

The information presented here is not nor should it be treated as investment, financial, or tax advice and is not intended to be used to make investment decisions.

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Information Asymmetry in Private Company Transactions

Information Asymmetry in Private Company Transactions

What is Information Asymmetry?

In 1970, George Akerlof, an economist who is currently a professor at the McCourt School of Public Policy at Georgetown University, released what is now a famous paper, “The Market for Lemons: Quality Uncertainty and the Market Mechanism.”[1]  The paper examines the market for used cars, and the impact that information asymmetry has on the pricing of cars.  The results of the paper have wide-ranging implications.  Information asymmetry occurs when one party in a transaction (i.e., the buyer or the seller) possesses greater material information regarding the subject of the transaction (i.e., the asset or security being sold in the transaction). 

When purchasing a used car, the car could either be a “good car” or a “lemon” (i.e., a “bad car”).  At the time of purchase, due to the limited time spent driving the car, an incomplete history of the car’s maintenance, a lack of knowledge regarding the prior owner’s driving habits, and the lack of a thorough mechanical evaluation of the car, the buyer cannot be certain whether the car is a good car or a lemon.  The seller, who we assume in this case is the prior owner, possesses all of this information.  Following the purchase and after spending additional time with the car, the buyer will develop a greater ability to predict whether or not the car is a lemon; however, this is too late, as the buyer has already purchased the car. 

Thus, the market for used cars is an imperfect one, where the buyer possesses less information regarding the quality of the product than the seller does.  Akerlof points out that in a used car market with asymmetric information, buyers are willing to pay less for a car, due to their inability to distinguish between a good car and a lemon, resulting in sellers of good cars exiting the market.  This trend results in buyers overpaying for inferior products. 

This phenomenon is seen in the health insurance market as well.  As insurance companies raise the price of insurance, it begins to attract unhealthy individuals, who are more certain of their need for insurance.  Thus, the average medical condition of insurance applicants deteriorates as the price rises.

Information Asymmetry In Private Company Transactions

Implications for Buying/Selling a Company

When purchasing a company, naturally the seller possesses greater information about the company than the buyer.  This results in long, drawn out due diligence processes.  One often overlooked component of due diligence is a Quality of Earnings (QoE) analysis.  The intent of this analysis is to reveal any abnormalities in the financial reporting process and control for one-time events and accounting policies.  The financial statements can be manipulated, intentionally or not, by the seller which results in unreliable figures, such as overstated profitability.  This can lead to a dramatically exaggerated valuation of the company, resulting in lower returns to the buyer. 

QoE analysis is particularly important when purchasing a private business, as those companies are not required to follow generally accepted accounting principles (GAAP).  Often these companies have non business-related expenditures buried in the financial statements, which can be revealed in a QoE analysis.  The following table illustrates this example and the potential impact.

Information Asymmetry In Private Company Transactions

Each company in the table is identical, but for the owner’s compensation line.  Company A’s owner is compensated via a distribution, which will not appear in the income statement, while Company B’s owner takes a salary.  If a thorough analysis on these income statements is not performed, the value of Company A appears to vastly exceed Company B but, in reality, they are worth the same.  The buyer of Company A would be thoroughly disappointed upon realizing that they need to now factor in compensating a new CEO.

The same can be true in reverse; take a look at the following example.

Information Asymmetry In Private Company Transactions

Again, we have two identical financial statements, with the exception of one-time expenses.  Company A relocated offices and faced $200,000 of additional expenses.  While this could have other impacts on the business, for the purposes of this example we will assume it does not.  If the $200,000 remains in the income statement as an expense, this lowers EBITDA, thus lowering the value.  The seller is being penalized for a non-recurring expense that has no impact on the future of the business.

Conclusion

Information asymmetry can be detrimental to both the buyer and seller.  The buyer is purchasing a product for which the information possessed is insufficient to determine its true value.  The seller can be penalized due to the assumption of a lower quality product (i.e. the buyer assumes that the car might have unforeseen problems).  All of this culminates into an inefficient market, and when dealing with the purchase of a company, can have massive implications. 

[1]  Akerlof, George A., “The Market for ‘Lemons’: Quality Uncertainty and the Market Mechanism.” The Quarterly Journal of Economics, vol. 84, no. 3, 1970, pp. 488–500.  JSTOR, www.jstor.org/stable/1879431.

A QoE analysis is imperative when engaging in transactions, and ValueScope provides top of the line service at a fraction of the cost of larger firms.  Our team of PhDs, CFA Charterholders, and CPAs possesses expertise in valuation that is unmatched in the industry.

For more information, contact:

Marty Hanan is the founder and President of ValueScope, Inc., a valuation and financial advisory firm that specializes in valuing assets and businesses and in helping business owners in business transactions and estate planning.  Mr. Hanan is a Chartered Financial Analyst and has a B.S. Electrical Engineering from the University of Illinois and an MBA from Loyola University of Chicago.

Jason Wainwright is a Senior Manager at ValueScope Inc., Inc. In this position, he has worked on and managed numerous business valuations and projects for firms spanning multiple industries, including energy, defense, consumer products, professional services, and healthcare. Mr. Wainwright is a Chartered Financial Analyst and has a BBA in Finance & Economics from Texas Wesleyan University, and a Ph.D. ABD in Finance from the University of Texas at Arlington.

 

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Economic Overview – Third Quarter 2019

U.S. Economic Report – September 30, 2019

During the second quarter of 2019, the U.S. economy grew at an annual rate of 2.0% over the prior quarter.  Household spending has been a primary driver of growth, and the economy continues to perform strongly despite slowing global growth and headwinds from trade disputes.

Overview of the U.S. Economy

According to the third estimate released by the Bureau of Economic Analysis (BEA), the U.S. economy grew in the second quarter of 2019, with real gross domestic product (GDP) increasing at an annual rate of 2.0%, following a first quarter increase of 3.1%.  The increase in real GDP in the second quarter reflected positive contributions from PCE, federal government spending, and state and local government spending that were partly offset by the negative effects from private inventory investment, exports, nonresidential fixed investment, and residential fixed investment [1].  This brings the US economy its twenty-first consecutive quarter with positive GDP growth.  For comparison, the longest streak of consecutive quarters is thirty-nine, which occurred between 1991 and 2001.

Economic Overview Third Quarter 2019

Forecasters surveyed by the Federal Reserve Bank of Philadelphia predicted, on average, a 1.8% annual real growth rate for the third quarter of 2019 and 2.0% for the fourth quarter of 2019.  The forecasters predicted, on average, that real GDP will grow 2.3% in 2019, 1.9% in 2020, 2.0% in 2021, and 2.1% in 2022.  The forecast for 2021 was higher than previous estimates, while the forecasts for 2019, 2020, and 2022 were revised downward from previous estimates [2].

Population

Population growth is an important driver of long-term growth in an economy.  The total population increased from 327.7 million in August 2018 to 329.7 million in August 2019 [3].  The working age population (15-64) declined slightly from 206.6 million in August 2018 to 206.2 million in August 2019 [4].

Economic Overview - Third Quarter 2019

The labor force participation rate has hardly budged in recent years and remains lower than pre-2008 levels.  In August 2019, the civilian labor force participation rate was 63.2% [5].  The minimum participation rate in the past decade was 62.4%, recorded in September 2015, while the maximum of 66.4% was recorded in December 2006.  This is at least partially explained by the aging population but could be evidence of slack in the labor market.

Economic Overview - Third Quarter 2019

Employment

Nonfarm payroll employment, according to the Bureau of Labor Statistics (BLS), rose by 130,000 in August 2019.  The unemployment rate (U3) in August 2019 remained at 3.7%.  This is at the bottom end of the Federal Open Market Committee (FOMC) participants’ projections of the long-run natural rate of unemployment, which range from 3.6% to 4.5%.  The BLS reported job gains in federal government, health care, and financial activities [6].

Forecasters surveyed by the Federal Reserve Bank of Philadelphia predicted, on average, that the unemployment rate will be 3.7% in 2019, 3.6% in 2020, 3.9% in 2021, and 4.0% in 2022 [7].

The U6 unemployment rate, which includes all marginally attached workers and those employed part-time for economic reasons, declined from 7.4% in August 2018 to 7.2% in August 2019 [8].  The gap between U3 and U6 has declined from the 10-year high of 7.4% in September 2011 to 3.5% in August 2019.

Economic Overview - Third Quarter 2019

The average number of weeks unemployed has declined to near pre-2008 levels and has decreased over the past twelve months, from 22.6 weeks in August 2018 to 22.1 in August 2019 [9].  This is far below the 10-year high of 40.7 weeks in July 2011 and slightly above the low of 16.5 weeks in March 2008.  The number of jobless claims increased slightly, from 214,750 in August 2018 to 215,600 in August 2019 [10].

Economic Overview - Third Quarter 2019

Inflation

According to the BLS, the Consumer Price Index for All Urban Consumers (CPI-U) increased 0.1% in August 2019 on a seasonally adjusted basis.  Over the previous 12 months, the all-items index increased 1.7% before seasonal adjustment [11].  The index for all items less food and energy rose 2.4% for the twelve-month period ending August 2019.  The energy index fell 4.4% over the last year, while the food index increased 1.7%.  The price pressures measure estimates the probability that the personal consumption expenditures price index inflation rate will exceed 2.5% over the next twelve months.  This price pressures measure reported a probability of 2.2% in August 2019, which is below the average of 8.2% over the past two years [12].

Economic Overview - Third Quarter 2019

Forecasters surveyed by the Federal Reserve Bank of Philadelphia predicted, on average, headline CPI inflation to be 1.9% in 2019, 2.0% in 2020, and 2.2% in 2021.  Over the next ten years, forecasters expect CPI inflation to average 2.20% annually [13].

Interest Rates

The interest rate on the three-month Treasury bill decreased from 2.15% as of September 28, 2018 to 1.84% as of September 30, 2019 [14].  The interest rate on the ten-year Treasury note decreased from 3.05% to 1.68% over the same period [15].

Economic Overview - Third Quarter 2019

On September 18, 2019, the Federal Open Market Committee (FOMC) announced their decision to lower the federal funds target range to 1.75 – 2.00%.  The following charts display projections from FOMC participants of the midpoint of the federal funds target range at the end of each calendar year [16].

Economic Overview - Third Quarter 2019

The following table represents the market’s reactions leading up to and following the FOMC meeting.

Economic Overview - Third Quarter 2019

As of September 30, 2019, the yields on Moody’s Aaa-rated corporate bonds and Baa-rated corporate bonds were 3.01% and 3.88%, respectively [17].

The spread between the twenty-year Treasury Bond and the one-year Treasury Bill declined from 0.54% as of September 28, 2018 to 0.19% as of September 30, 2019 [18].  A combination of increasing short-term interest rates from federal funds rate hikes and tempered long-term growth expectations have caused the yield curve to flatten in recent years [19].  The spread between long- and short-maturity Treasury securities have long been used as a predictive measure for future economic performance.  A recent paper from the Federal Reserve showed that the probability of a near-term recession has increased in recent years.  However, when additional information was incorporated into their model, such as the excess bond premium, the component of corporate bond spreads in excess of an estimate of the compensation for expected default losses, the recession probability was significantly lower [20].

Economic Overview - Third Quarter 2019

Corporate Profits

According to the BEA, profits from current production (corporate profits with inventory valuation and capital consumption adjustments) increased $75.8 billion in the first quarter of 2019 over the first quarter, compared to a decrease of $78.7 billion in the first quarter of 2019 over the fourth quarter of 2018 [21].

Economic Overview - Third Quarter 2019

Stock Markets

The S&P 500 Total Return Index closed at 5,144.1 on September 28, 2018 and closed higher at 5,330.3 on September 30, 2019.  This corresponds to an annual return of 3.6%.  The Dow Jones Industrial Average Total Return Index closed at 58,028.5 on September 28, 2018 and closed higher at 60,471.5 on September 30, 2019.  This corresponds to an annual return of 4.2%.  The NASDAQ Composite Total Return Index closed at 9,322.1 on September 28, 2018 and closed higher at 9,370.9 on September 30, 2019 [22, 23].  This corresponds to an annual return of 0.5%.  In the graph below, the September 28, 2018 values were set to 100. 

Economic Overview - Third Quarter 2019

Construction & Housing Starts

Construction spending and housing starts are two other important indicators for the economy.  Construction spending may indicate the sentiment in real estate markets and the soundness of the economy while housing starts are an alternative indicator of consumer sentiment.  Increases in demand for newly constructed homes can lead to job growth in the construction industry, increased demand for appliances and furniture, and ripple effects throughout the economy.  Housing starts increased from 1.279 million units in August 2018 to 1.364 million units in August 2019 [24].  Construction spending, a seasonally adjusted annual figure, decreased from $1.312 trillion in August 2018 to $1.287 trillion in August 2019 [25].

Economic Overview - Third Quarter 2019

Consumer Confidence

The Conference Board reported that the Consumer Confidence Index declined in September 2019 to 125.1 from 134.2 in August [26].  The index is based on a survey of consumer perceptions of present economic conditions and expectations of future conditions.  The survey is based on a representative sample of 5,000 U.S. households and is considered a leading indicator of future consumer expenditures and economic activity.

The University of Michigan Survey of Consumers reported that the Index of Consumer Sentiment decreased in August 2019 to 89.8, down from 98.4 in July 2019 and 96.2 in August 2018 [27].  The index is based on a survey of consumer perceptions of present economic conditions and expectations of future conditions.  The survey is based on a sample of 500 phone interviews consisting of 50 core questions conducted across the continental U.S.  This is considered a leading indicator of future consumer expenditures and economic activity.

Economic Overview - Third Quarter 2019

In September, the survey focused on the variation in consumer sentiment based on political party affiliation.  The survey results are presented in the following table.

Economic Overview - Third Quarter 2019

Conclusion

In conclusion, the economy performed well in the second quarter of 2019; however, it has shown signs of slowing down.  Economic growth has slowed, and many economists have revised growth expectations downward.  The yield curve remains inverted, with the 10-year Treasury bond falling below the 3-month Treasury bill.  Every recession since the 1960s has been preceded by an inversion of the Treasury yield curve.  Inflation has been modest, and the labor market remains tight with the unemployment rate hovering around the FOMC participants’ projection of the natural rate of unemployment.  Equity markets have rebounded from a dip at the beginning of August 2019.  Consumer sentiment remains optimistic with a wide divergence based on the individual’s political party.

Federal Reserve Chairman Jerome Powell recounted his thoughts on the economy’s performance at post-meeting press conference on September 18, 2019:

The U.S. economy has continued to perform well.  We are into the 11th year of this economic expansion, and the baseline outlook remains favorable. The economy grew at a 2½ percent pace in the first half of the year.  Household spending—supported by a strong job market, rising incomes, and solid consumer confidence—has been the key driver of growth.  In contrast, business investment and exports have weakened amid falling manufacturing output.  The main reasons appear to be slower growth abroad and trade policy developments—two sources of uncertainty that we’ve been monitoring all year.

The following table displays a summary of the economic indicators, their performance over the past year, and whether this is viewed as a positive or negative sign for the economy at large.  The leading, lagging, and coincident indices were obtained from The Conference Board and were measured as of August 2019 [28].

Economic Overview - Third Quarter 2019

[1]      U.S. Department of Commerce, Bureau of Economic Analysis, Gross Domestic Product: Second Quarter 2019 (Third Estimate), September 26, 2019

[2]      Federal Reserve Bank of Philadelphia, Third Quarter 2019 Survey of Professional Forecasters, August 9, 2019

[3]      U.S. Bureau of Economic Analysis, Population [POPTHM], retrieved from FRED, Federal Reserve Bank of St. Louis, October 10, 2019

[4]      Organization for Economic Co-operation and Development, Working Age Population: Aged 15-64: All Persons for the United States [LFWA64TTUSM647N], retrieved from FRED, Federal Reserve Bank of St. Louis, October 10, 2019

[5]      U.S. Bureau of Labor Statistics, Civilian Labor Force Participation Rate [CIVPART], retrieved from FRED, Federal Reserve Bank of St. Louis, October 10, 2019

[6]      United States Department of Labor, Bureau of Labor Statistics, The Employment Situation: August 2019, September 6, 2019

[7]      Federal Reserve Bank of Philadelphia, Third Quarter 2019 Survey of Professional Forecasters, August 9, 2019

[8]      U.S. Bureau of Labor Statistics, Total unemployed, plus all marginally attached workers plus total employed part time for economic reasons [U6RATE], Civilian Unemployment Rate [UNRATE], retrieved from FRED, Federal Reserve Bank of St. Louis, last accessed October 10, 2019

[9]      U.S. Bureau of Labor Statistics, Average (Mean) Duration of Unemployment [UEMPMEAN], retrieved from FRED, Federal Reserve Bank of St. Louis, October 10, 2019

[10]      U.S. Employment and Training Administration, Initial Claims [ICSA], retrieved from FRED, Federal Reserve Bank of St. Louis, October 10, 2019

[11]      United States Department of Labor, Bureau of Labor Statistics, Consumer Price Index: August 2019, September 12, 2019

[12]      Federal Reserve Bank of St. Louis, Price Pressures Measure [STLPPM], retrieved from FRED, Federal Reserve Bank of St. Louis, October 10, 2019

[13]      Federal Reserve Bank of Philadelphia, Third Quarter 2019 Survey of Professional Forecasters, August 9, 2019

[14]      Board of Governors Federal Reserve System, 3-Month Treasury Bill: Secondary Market Rate [DTB3MS], retrieved from FRED, Federal Reserve Bank of St. Louis, last accessed October 10, 2019

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[16]      Federal Open Market Committee, Summary of Economic Projections, September 18, 2019

[17]      Moody’s, Moody’s Seasoned Aaa Corporate Bond Yield© [DAAA], Moody’s Seasoned Baa Corporate Bond Yield© [DBAA], retrieved from FRED, Federal Reserve Bank of St. Louis, last accessed October 10, 2019

[18]      U.S. Department of the Treasury, Daily Treasury Yield Curve Rates, last accessed October 10, 2019

[19]      Johansson, Peter, and Andrew Meldrum (2018). “Predicting Recession Probabilities Using the Slope of the Yield Curve,” FEDS Notes. Washington: Board of Governors of the Federal Reserve System, March 1, 2018, https://doi.org/10.17016/2380-7172.2146.

[20]      Gilchrist, S., and E. Zakrajšek (2012), “Credit Spreads and Business Cycle Fluctuations,” American Economic Review 102(4), pp. 1692-1720.

[21]      U.S. Department of Commerce, Bureau of Economic Analysis, Corporate Profits: Second Quarter 2019, September 26, 2019

[22]      Total return indices include returns from both income and capital gains

[23]       S&P Capital IQ Database, last accessed October 10, 2019

[24]      U.S. Census Bureau and U.S. Department of Housing and Urban Development, Housing Starts, New Privately-Owned Housing Units Started [HOUST], retrieved from FRED, Federal Reserve Bank of St. Louis, last accessed October 10, 2019

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[26]      The Conference Board, Consumer Confidence Index, September 24, 2019

[27]      University of Michigan, Surveys of Consumers, September 2019

[28]      The Conference Board, The Conference Board Leading Economic Index® (LEI) for the U.S. Remained Unchanged in August, September 19, 2019

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