Several factors point to lowered stock price for the near-term.
First off, stocks surged Tuesday afternoon. The surge came just after the Federal Reserve announced it would do something it hasn’t done since the financial crisis: provide a credit facility in the commercial paper market.
The commercial paper market is the market between companies and lenders, who provide very short-term and low interest loans to businesses purchasing inventories and paying down short-term liabilities like accounts payable. Companies want to remain as liquid as possible, even in the short-term.
With the coronavirus raging and revenues likely falling hard from previous exceptions, credit quality is worsening and there have been murmurs that the commercial paper market is drying up.
The Federal Reserve announced Tuesday that it will support the commercial paper market, using a fund with billions of dollars allocated for this special purpose. That fund will extend commercial paper to companies. The Federal Reserve has special authority to invoke this action and it is supported by $10 billion sent from the Treasury Department, which protects the Fed against poor credit.
This is all good news for the near-term and it gives the market confidence.
But let’s look a bit closer at the market and the economy.
Investors have no idea when the coronavirus will be contained, which means that earnings could be in free fall mode, just as stock prices have been. The consensus earnings per share estimate for 2020 has fallen to $167 from $178, but many strategists say that number could fall even more from here.
A falling EPS number would also be a negative for the earnings yield on the index. That yield is earnings per share divided by the price level of the index, measuring how much return investors can expect on stocks for the next year.
Subtract the safe and secure 10 year treasury yield from that yield to get the equity risk premium, or the excess rate of return investors expect in being in stocks.
Historically, that risk premium sits around 3%, but when the market prices in a recession, it is pricing stocks lower in order to achieve a higher yield and a higher risk premium. That premium is just under 6% currently, but Yardeni Research shows that the premium, before recessions can hit above 9%. Before the Great Recession, it hit 9%. It hit 12% in the early 1980’s.
And interest rates are not gong to fall too much from current levels, so stock prices would have to fall.
The Great Recession was severe and caused by a banking liquidity crisis, which may not be in the cards right now. A 7% risk premium would imply an S&P 500 level of about 2,380, or a 4.7% drop from the current level.
Even worse, Stifel’s Head of Institutional Equity Strategy, Barry Bannister wrote in a note that the recession that he says has already begun implies a near-term S&P 500 level of 2,300, or am 8% drop in the near future.
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