S&P 500: 400 Bps Can Cause A 50% Loss

| About: SPDR S&P (SPY)

Summary

S&P 500’s earnings yield is going lower and lower, currently at 4%.

Low earnings yield today does not reflect the fact that earnings yield will increase in the future as profits increase.

According to Standard & Poor’s estimates, the S&P 500 could rise by 44% by the end of 2017 if the current earnings yield is maintained.

Changes in the fair yield are a far bigger problem. A 400 bps change can wipe out 50% of the index.

We can solve the fair yield problem by having a long investment horizon.

"Picking up pennies in front of a steamroller" refers to an investment strategy where one has to risk a lot to gain very little. Counterintuitively, such strategies are often perceived to be safe. For example, before Long-Term Capital Management's collapse, everyone thought that its complex arbitrage strategies provided great risk-adjusted returns. There were a lot of pennies to pick up, but inevitably, the company slipped up and was crushed.

The S&P 500 (NYSEARCA:SPY) is much simpler from an index investor's perspective, but an investment in an index (QQQ, DIA) still adheres to the general principle of risk and reward: the reward being earnings and the risk being the loss of principal. From a risk-reward perspective, you would want earnings to be as high as possible and the principal to be as low as possible; this is why investors are always clamoring after high yield investments. Today, the S&P 500 is yielding just 4%. This number has been declining ever since we got out of the recession, and we've long passed the pre-recession earnings yield.

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So applying the risk-reward framework, the index is getting less and less attractive, as we are risking more and more to earn less and less. On the surface, it would seem that investors are indeed "picking up pennies in front of a steamroller." However, I believe that such an opinion fails to account for growth.

It's true that the S&P 500 has risen substantially over the past couple of years, but so have profits.

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The scale of the earnings graph exaggerates the magnitude of the changes in profits. Profits have not risen significantly, but growth has been positive. Since the S&P 500 grew at a quicker pace, it's no wonder earnings yield has been declining.

I'm sure you've also noticed that profits trailed off in 2016, but the index did not fall, compressing the yield even further. This has given the bears a lot of ammunition. However, the market is forward looking (at least most of the time), and right now the future looks pretty good. You can read my opinion about the current state of the economy in this article, but don't just take my word for it, Standard & Poor's also agrees with me. The chart below shows the expected earnings yield if the S&P 500 stays flat.

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Theoretically speaking, if the 4% yield were to be maintained at the end of 2017, the index would have to rise by 44%! Not too shabby for just holding the index for less than two years. So based on my positive outlook of the economy and Standard & Poor's estimate of future earnings, the S&P 500 isn't a bad deal at all.

However, the above assumes that 4% is indeed the fair yield. If the fair yield were to suddenly increase to 8%, then the index would have to lose half of its value in order to maintain the fair yield. Unfortunately, there is no single definition of fair yield, and I see this as a far bigger problem than any of the bears' arguments about the current state of the economy. At the end of the day, the fair yield is governed by sentiment (i.e. risk appetite), not by logic, so it is very difficult to pin down. If you are interested, you can read about one of my proposals here (read S&P 500's Downside). While the prospect of losing 50% of your investment if the fair yield jumps just 400 bps sounds unappealing, we can essentially remove this risk by having a long investment horizon. In the world of fixed-income, investors can lock in a rate of return (assuming no reinvestment) by holding a bond to maturity. Similarly, if the fair yield increases to 8%, the implication is that future returns will be higher (i.e. 8% vs. 5%). The portfolio that endured the fair yield increase will inevitably catch up to the slower growing portfolio given enough time.

Conclusion

Investors are not picking up pennies in front of the steamroller today. On the contrary, the future looks very bright given Standard & Poor's earnings forecasts and my positive outlook for the economy. A more real risk is one that is purely valuation related. If the fair yield increases just by 400 bps, the S&P 500 could theoretically drop by 50%. However, if we approach equities with a long investment horizon, we can effectively neutralize this risk. If you agree with this line of thought, I think you will find the V20 Portfolio quite interesting.

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Disclosure: I/we 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.