Update On S&P 500 P/E Ratios Are Inversely Related To Future Federal Spending

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Includes: SPY
by: Lance Brofman

Analyses that we conducted in 2010 and in 2012 attempted to identify those macroeconomic variables that could best explain the level and variation in the price-earnings ratio ( the market multiple) for the S&P 500 index. Our analyses utilized data from 1960 to the present since 1960 is when the index first began to be calculated. We used the concurrent period multiple as the variable we were attempting to explain and then predict. See: "The Market Multiple On The S&P 500 Can Be Explained: P/E Ratios Are Inversely Related To Future Federal Spending" seekingalpha.com/article/1522942

Of the many possible explanatory variables our best historical fit was gotten using a forward looking moving average of the ration of federal outlays to GDP two to five years ahead. The relation was inverse meaning that if the equity market in its infinite wisdom could sense a decline in this ratio into the future, it would be a positive for an expansion in the market multiple and vice versa.

Until this past year there were widely diverging views of government's prospective role in the economy. Led by Rep. Paul Ryan, republicans supported a pattern in which government's role would shrink dramatically over the next ten years. Meanwhile, the Obama administration and Democrats generally have been proposing a future in which government's role dominates. Spurred by spending restraint that was dictated by the 2011 Budget Control Act, and by recent tax compromises, a middle ground is emerging as a consensus.

This middle ground is laid out as the Congressional Budget Office (CBO) baseline budget forecast and it is shown in the accompanying table. The fact that the CBO regularly updates ten year forecasts of the budget situation offers a general guide to the direction of government relative to the economy. The table shows a generally declining ratio for the remainder of this decade and then a resumption of an upward trend as entitlement costs begin to explode. Using this projected path in our model formulation would have generated a 2012 market multiple of 13.6 versus the actual 13.9 multiple that was officially recorded.

While this outcome was encouraging we sought a further refinement by incorporating the yield on the ten year Treasury note as an explanatory variable. This variable was statistically significant and it improved the historical correlation. The interest rate effect is inverse in that a rise in yields would be consistent with a falling multiple and vice versa. Interest rates are also correlated with the government ratio and directly in the sense that a rise in yields would tend to occur in tandem with a rise in the government ratio.

Over the past three years this relationship broke down however, as the government ratio rose dramatically while long term interest rates fell dramatically. As just noted, in 2012 the simple model that utilized just the government ratio very closely predicted the actual market multiple. But upon including the ten year treasury note yield which was about 1.75% in 2012, the model forecast a multiple of 19.1 -- a huge overshoot.

We think this overshoot reflects the fact that the "market" did not consider this low level of interest rates to be legitimate; that rates were being artificially suppressed by the Federal Reserve's extraordinary effort to foster an economic recovery. Indeed, our model would have required a 7% yield on the treasury ten year to meet the actual recorded multiple of 13.9 for 2012.

As shown on the accompanying table the CBO baseline interest rate path for the treasury ten year is for a gradual rise to about 5% over the next ten years. In no year does the forecasted interest rate come close to the 7% rate that our model says would be required to match up with the actual recorded multiple of 13.9 for 2012. Indeed, if interest rates were to conform to the CBO forecast path and so too for the government ratio, our model would show a rising multiple going forward. Of course, the model shows higher multiple over time albeit lower than the 19.1 level that it forecast for 2012.

The point of this exercise is that if government's role in the economy is contained, even a period of gently rising interest rates would be consistent with an expansion of the market multiple. But going beyond this, there is the possibility that the market may be wrong in its assessment that interest rates are being pegged at an artificially low rate. The longer inflation stays very low or goes lower; the longer the global economy remains mired in slow growth; and the longer Central Banks engage in quantitative easing that is not perceived as reckless, the more likely it is that the current environment of very low interest rates is perceived as warranted and representative of a "new normal".

In such an environment we would expect the market multiple to expand over time, ultimately approximating the 19.1 reading that was the model's predicted value for 2012. This is illustrated on the accompanying table along with a forecast of the actual S&P 500 that would be derived from the estimated multiple and the assumption that corporate profits would rise in line with nominal GDP.

Of course the CBO baseline forecast path does not allow for any business recessions and it makes some heroic assumptions about the path of the budget deficit and the government ratio. But this is not all unusual. Conversely our assumption that profits rise in line with nominal GDP may be conservative in that it does not allow for the positive effect of productivity and innovation to say nothing of possible energy independence and health care innovation. Finally the forecast path does not explicitly account for cross border fund flows that might be influenced by exchange rate perceptions.

We will be watching and monitoring all the moving parts of this analysis going forward. But our market multiple should serve as a useful formulation to determine if trends currently in place are enduring.

CBO Assumptions and Market Multiple

actual

2012

2013

2014

2015

2016

2017

2018

2019

2020

2021

2022

2023

GDP % change

4.1

2.9

4.4

6.2

6.6

6

4.7

4.5

4.4

4.3

4.3

4.2

Real GDP % change

2.3

1.4

2.6

4.1

4.4

3.8

2.6

2.4

2.3

2.2

2.2

2.2

Federal Spending % GDP

22.7

21.5

21.6

21.4

21.5

21.3

21.4

21.7

21.9

22.1

22.6

22.6

Future spending +2-5 yrs

21.47

21.42

21.49

21.6

21.79

22.09

22.32

10-year treasury

1.8

2.1

2.7

3.5

4.3

5

5.2

5.2

5.2

5.2

5.2

5.2

% change in corporate profits

6.1

1.5

6.8

7.6

8

3.1

-0.4

0

1.2

1.9

2.1

1.9

S&P 500 earnings

102.47

104.06

111.2

119.6

129.2

133.24

132.73

132.68

134.2

136.73

139.55

142.3

S&P 500 index (model)

19.1

19

18.4

17.6

16.6

15.6

15.2

S&P P/E

1426.2

1973

2044

2103

2146

2084.6

2015.4

P/E if 10-Year 1.75% to 2018

19.23

19.13

18.98

18.71

18.3

18

S&P 500 index (model)

2000.6

2126

2270

2418

2438.6

2388.8

Click to enlarge

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Please note that this article was written by Dr. Vincent J. Malanga and Dr. Lance Brofman with sponsorship by BEACH INVESTMENT COUNSEL, INC. and is used with the permission of both.