Macro bears should do DCFs: a bottoms-up approach to bearish S&P 500 calls
"However beautiful the top-down macro call is, you should occasionally look at the individual companies" - probably Churchill in an alternative universe
Here's an observation I've made in the finance realm that can't be ignored: a large number of macro bears have turned bearish on the market, their confidence bolstered by a confluence of perceived risks. Rising rates, mounting inflation, alleged overvaluations, and a lack of market breadth paint a grim picture. These voices in the wilderness prophecy an imminent index dip below 3,000, although their reasons remain as elusive as their steadfast conviction.
Such a perspective is not uncommon amongst the macro bears' community. A profound certainty underscores their belief: a downturn in the economy lurks around the corner. The repetitive chorus they sing together? The earnings per share (EPS) of the index will tumble down and start trading at lower multiples. A double whammy. The familiar tune of pessimism, once you've heard it a few times, becomes quite predictable.
But here's a thought that bothers me: Do these overarching macro predictions harmonize with the ground-level realities of individual companies? It's an important question, one that calls for introspection. Take, for instance, an 'average' company that achieves organic growth of around 2-3%, a number facilitated by the steady drumbeat of inflation. This kind of growth, when you think about it, makes a 20-25x earnings power multiple seem quite reasonable for a well-performing company.
Now, let's not get abstract about the term 'average company.' These are real, tangible businesses we interact with daily. Companies like Danaher, Avago, Schwerin-Willians, UnitedHealth Group, Mastercard, Union Pacific - each carving their own path in their respective markets, maintaining growth trajectories despite global headwinds.
Of course, we cannot ignore the giants in the room - the FAAMG+NT. These behemoths constitute a substantial 25-30% of the index, a size that calls for individual attention rather than a collective dismissal. These companies don't warrant a fleeting 'top-down' glance; they deserve an exhaustive discounted cash flow (DCF) analysis. DCF allows us to unmask their true value, a necessity when dealing with entities of their magnitude.
Let's dig a little deeper into the financial intricacies. A minor shift in the cost of equity (Ke), say a 1% reduction, is akin to installing a turbocharger to the net present value (NPV) of a company. The impact is significantly more powerful than what a 30% profit cut next year could ever achieve. Look at Microsoft. Using my DCF, a small 1% Ke reduction equates to a staggering 21% increase in NPV. This isn't mere number play; it's a considerable shift.
This also addresses the 2022 story.
ce Grantham’s Let the Wild Rumpus Begin was published in January 2022, his long picks like EWJ is down 5%, emerging market value is down 1.6%, and while gold is up 7%, silver is down 20%. On the short side, the S&P 500 is down 5%. Who was to blame for the S&P 50P? TLT, of the long-term U.S. treasuries, down 25%. EPS? Down 6%.
Macro bears, in their habitual pessimism, often invoke the specter of equity-risk premiums. However, these, like P/E multiples, are tautological entities, as Peter Lynch would say. You need the price to calculate the P/E, and you need the P/E to calculate the price. This circular logic doesn't escape the keen observer. Moreover, it's crucial to remember that not every recession mimics the cataclysms of 2008 or 2020. Recessions are inherent in the business cycle, a fact well understood by the market. The idea that people will pay significantly higher market-risk premias (particularly in a high-inflation environment) in a fed-induced recession isn’t the greatest plan. This is because many bears think a recession is like 2008 and 2020 (second and largest recessions of the post-war, respectively), but in fact, is more akin to ‘91 or ‘01.
If we pause to lend an ear to the companies themselves, we might glean insights into what a 'bad year' might entail. Often, it's not as catastrophic as macro bears would have you believe. As a result, the prospect of a recession without a substantial dip in the index is not as fantastical as it may seem. Particularly, after you consider we already got a 25% drawdown for the index and most companies are still below their all-time highs.
Fast-forward to the present. We're already in an 8% inflation environment, and we're witnessing a 6% trailing twelve-month (TTM) EPS drawdown. When inflation is factored into the equation, this number jumps to over 15%. Each sector is weathering the storm in its own way: financials are facing a 40% EPS drawdown, information technology 10%, communication services 29%, consumer discretionary 12%, and real estate 20%. However, it's not all doom and gloom. Sectors like energy and industrials are still soaring to new heights, showing that strength persists amidst turmoil.
Here's a morsel of advice for the macro bears out there: Handpick a handful of representative companies, even at random. Demonstrate how your 'top-down' approach influences them on a micro-level. A broader macroeconomic perspective is valuable, but it must be tempered with an understanding of the granular-level operations. And cover the FAAMG+NTs!
If not, it becomes a tough task reconciling such an overarching bearish sentiment with the resilience we observe in the 'average' company. This kind of resilience is not a random anomaly; it's a testament to the inherent strength of businesses, their adaptability, and their determination to weather any economic storm. Macro bears, take note: DCF is not a suggestion; it's a necessity. Otherwise, when your recession arrives, you’ll be shorting an index that will be benefiting from lower cost of capital and companies that have levers to protect their earnings power (and a market that will know that for many of these companies, the lower profits are temporary).