S&P 500: The Danger Zone

| About: SPDR S&P (SPY)

Summary

Always remind yourself of the upper limit of the market.

Based on 30 years of earnings yields, I believe that 2752 is a critical level.

2752 implies an earnings yield of 3.17%, the 10th percentile of last 30 years' earnings yields.

The narrative only makes sense if profits continue to grow.

A sudden surge in the value of the index would be more troubling than a temporary earnings recession.

While my economic outlook remains very positive and I believe that the stock market (SPY, DIA, QQQ) still has a lot of room to run, it's still important to understand the upper limit of the market. There is nothing that can foretell a crash with absolute certainty, but knowing when the market is getting too frothy will definitely help.

First I must say that the fact that the stock market is at all-time highs has no impact on whether there will be a crash or not. As long as the fundamentals are there to justify the growth, the S&P 500 could be at 4000 and I wouldn't bat an eye.

That being said, I believe that investors should get a bit nervous if the index suddenly surges to 2752 in the near term.

Why 2752?

The current earnings yield is 3.96% based on TTM earnings ending Q1 ($86.44). Although Q2 earnings aren't official yet, Standard & Poor's has a pretty good idea of what earnings should be given that many companies have reported already. Based on Standard & Poor's estimate of $23.59 for Q2, we arrive at TTM earnings of $87.23 ending Q2, bringing the index's current earnings yield to 4.00%. It's still low, but it is an improvement over Q1's yield.

As I mentioned in my other article, risk is relative. For this calculation, I've set my threshold at the 10th percentile of last 30 years' earnings yields, which is 3.17%. This means that the S&P 500 needs to rise 26% to 2752 (to lower the yield from 4% to 3.17%) before the market would be considered expensive, in that future returns will no longer justify the investment.

Keep in mind that profits will grow in the future, which is why 2752 is only a good measure of S&P 500's ceiling over the short-term. By Q3, earnings would have improved, meaning that we'll have to adjust this ceiling to reflect higher earnings.

The idea that the current stock market is not expensive rests on the narrative that growth will indeed materialize. In my last article I talked about the drop in corporate profits in 2015. Much of the decline can be attributed lower oil prices. While oil has not rebounded significantly when compared to its price in 2014 or even 2015, there won't be a sequential decline in profits because oil companies' losses won't accelerate if oil just fluctuates within a range (i.e. $40/$50). Energy companies could continue to lose money, but other sectors will grow, resulting in a sequential increase in aggregate profits. Given my positive economic outlook, there is no reason to suspect that growth will suddenly taper off. While I don't have the time to look at every single company in the index, my macro view conforms to that of Standard & Poor's in that I believe aggregate earnings will indeed increase going forward.

Conclusion

Based on current earnings estimates and my outlook of the economy, I believe that 2752 is the critical level where investors should start to get nervous. Beyond 2752, the earnings yield would be extremely low (bottom 10%) by historical standards. As investors, we want to risk less and earn more, so it would not be attractive to buy when the yield is that low. Of course, we saw yields decline in 2015, but the decline was temporary as it was brought on by a temporary "earnings recession" thanks to oil prices. If earnings yield fall as the result of a rapid increase in index value as opposed to temporarily shrinking earnings, that is when we need to be concerned about a potential bubble. Until we are sufficiently close to the danger zone, I believe that equities' outlook remains bright.

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