TCS Daily


Are Investors Making A Market Bomb Out Of An Economic Blip?

By Kevin Hassett - February 26, 2001 12:00 AM

With all the negative talk about earnings, and the continued threat of recession, it may be useful to pause for a minute and think about blips. If history is any guide, recessions have always been blips, little downturns that are hardly perceptible if you plot GDP over the post-war period. The typical recession lasts less than a year, and posts growth of about minus one half of one percent.

In the scheme of things this is one tiny blip. This was driven home to me last week while I was flipping through the Congressional Budget Offices forecast of the government surplus over the next decade. The CBO provided an analysis of the impact on revenues of a recession this year, and the news was pretty surprising. The baseline (no recession) forecast calls for the surplus over the next ten years to be about $5.6 trillion. If we have a recession this year, the surplus will, the CBO projects, be only $5.46 trillion over the same ten years. As far as government revenues are concerned, a certain recession is about ten times smaller than the forecast's margin of error.

Surveying the response of the stock market to recent negative earnings news, I have the feeling that the market has forgotten that past interruptions to the general upward trend of profits have all been blips. A little calculation helps make the point quite clear.

In Dow 36,000, Jim Glassman and I argue that a simple heuristic model can be very useful for thinking about valuing stocks. In this model, a firm experiences two phases of life: adolescence and maturity. During adolescence, firms grow very quickly. During maturity, the firm gradually shrinks relative to the economy as a whole. The value of the firm is just the present value of current and future earnings, discounted back to today.

The analogue to the CBO calculation is quite straightforward. How should a profit blip affect the value of a stock today? Gentlemen, start your spreadsheets.

To explore this question, I gathered the earnings and earnings growth data for Microsoft from the Yahoo web page. Microsoft is projected to have 2001 earnings of $1.80, and analysts project those earnings to grow at 17.5 percent per year over the next five years. Since some earnings have to be plowed back into the firm to make the firm grow, only some of that $1.80 is free cash that can be counted toward value. Research Jim and I did suggests that is about 70 percent of earnings.

To start the calculations, I assumed that adolescence would last another 5 years for Microsoft, and then it would become mature and grow its real earnings 2.5 percent per year. I found that a discount rate of 9.1 percent equated the present value of cash flow to the current price of about $57. The market is demanding, under the assumptions outlined above, about a 3.5 percent higher return from Microsoft than it does from a Treasury bond. If we have a recession and their earnings don't grow at all this year, but then Microsoft grows its earnings for four more years at the high rate, then the present value drops do $48.72. If the growth rate of earnings is only half of the analyst expectation, then the present value drops to $52.87.

Neither one of those reductions is that large, and presumably the current price already capitalizes in the market's perceived probability of recession. The calculations go the same for the rest of Nasdaq. Even a full-fledged recession has very little impact on the present value of the firm's earnings stream.

Given the large decline that many firms have experienced as recession fears have become more real, it is clear that the market has not assumed that the earnings shortfall will be a typical blip. The negative earnings path consistent with current stock market levels seems excessively pessimistic.
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