EPS projections and the mistrust of the volatility market

Our two new scenarios for GDP growth are now including a worst case scenario that’s even worse than the 2008-2009 decline in GDP and a base case scenario that’s a bit milder and recovers to around trend growth by 2021.

Based on a fitted quantile regression model of quarterly GDP growth and quarterly changes in GDP growth since 1954 we predict EPS path at different percentiles. The median of the two EPS paths implies 12-month trailing EPS being down 21% in the worst-case scenario by Q4 2021 and down 10% in the base case scenario. The 25% percentile paths provide a picture for how much EPS could decline under more severe downside dynamics. These paths takes EPS down by 35% in the base case scenario and down by 45% in the worst case scenario.

With the S&P 500 drawdown at 34% and assuming unchanged valuation multiples it gives a market-based input to how much earnings could be down. If the worst case scenario plays out and we get a severe credit crisis then we could see new lows in S&P 500 and EPS decline of close to 50%. Time will soon tells us where the world is headed.

As we pointed out in our Market Call podcast this morning the VIX Index remains elevated above 60 suggesting more downside risks to equities in the short-term. But the VIX futures term structure also remains in steep backwardation with the second month contract on the curve trading at 37% discount to the VIX Index. But even more importantly the second month contract has risen in recent days despite the rally in equities suggesting the volatility market is not yet believing that equities have turned a corner.