S&P 500: Risk and Cost of Capital

In an earlier post, I explained why I thought the market was cheap, although I’m not sure I did a good enough job explaining the situation. The price you are (or should be) willing to pay for an asset should be based on two things: risk and cost of capital. If you could make a risk free investment and have it return greater than your cost of capital, then you should make that trade (and repeat until you are a trillionaire).

In the above-mentioned post we covered risk, which in the case of equities boils down to two things: market risk (i.e. everyone getting fearful and selling, which you have no control over) and earnings risk. The earnings chart showed that earnings for the S&P 500 actually aren’t all that risky; they have steadily grown at a rate of about 5.85% since 1950 even after you factor in this year’s huge fall in earnings. The market risk is uncontrollable; it could contribute to above normal returns (when everyone gets happy, see the tech bubble and this last bubble for an example) or below normal returns (see 2008).

So, in the realm of things you can control or understand, you are left with earnings and cost of capital. The below chart shows the 10 year trailing average earnings yield (earnings divided by price) of the S&P 500 from 1962 to present (the last 2 quarters of earnings I guesstimated to be $45 and $40 on a TTM basis).

The textbooks say that you should adjust Treasury yields downward for inflation, because the principal on the bond doesn’t increase in value with inflation. I haven’t bothered to do that on the chart above, since it just confuses matters. What the chart shows is that there is a definite correlation between 10 year Treasury yields and the trailing 10 year earnings yield on the S&P 500, over the long term. Meaning, when Treasury yields decrease, we also tend to see earnings yields decrease (or P/E multiples increase).

So all else equal, in an environment with 2.5% 10 year yields, we might expect to see 2% earnings yields (that’d be 50x trailing 10 year earnings or $52.15 x 50 = 2,607 on the S&P). As I’ve said before, this is a unique circumstance, so I wouldn’t expect to see 2,607 on the S&P anytime soon. What is much more likely to happen is the S&P 500 earnings yield begins to decrease while the 10 year Treasury yield starts to increase. You will probably get some convergence over the next year or two, probably around 4%, which will leave the S&P 500 around 1,300.

The next chart is more for fun, since it’s hard to know what it means exactly. The fundamental theory behind investing in stocks is that you have ownership on a stream of future earnings. The idea behind owning bonds is that you get paid interest. If we ignore one component of stock returns (capital) and pretend that by owning the S&P 500 you got paid all earnings (i.e. we made it more like a bond) for the next 10 years, and we compared them to the compounded return of 10 year Treasuries… what would it look like? I thought that stocks would have a much better cumulative “return” than bonds based solely on their earnings “payouts” (which obviously don’t occur, since most companies don’t have 100% dividend payout ratios).

Since we are looking forward, I made a bunch of assumptions about the future earnings of the S&P 500 (I basically used the 10 year trailing number and increased it by 4% per year, below the historical average) and future 10 year yields (increased them slowly to 7%). I believe all of these assumptions to be conservative (i.e. favoring bonds over stocks), but time will tell.

Anyways, as it turns out, Treasuries outperform equities (for the most part) on this measure. A large part of equity returns (and their long term outperformance over Treasuries) is due to the “principal” inflating by at least the rate of inflation. However, even with conservative estimates, it looks like stocks (based solely on earnings and no capital return) are poised to outperform Treasuries over the next 10 years, as they were if you bought in 2003.