The US equities market has been mired in a sideways trend since mid-July, though the long-term trend is still very much up as, I believe, a consequence of years of ultra-low rates and quantitative easing measures from the most prominent central banks in the world. As I've mentioned in at least one previous article, I am very concerned about the current state of the global economy. Current stock market highs are largely not backed up by earnings growth, but by central bank measures that render safer assets, such as cash and bonds, unattractive by compressing their yields. This has incentivized investors to move into stocks, which represent the last viable alternative for yield.
Payout ratios in the current equities market, or the sum of dividends and net stock buybacks as a fraction of GAAP earnings, are currently above 100%. Corporations are responding to the lack of earnings growth by issuing more cheap debt to compensate for the shortfall.
Payout ratios in the market above 90% of profits are rare and tend to only occur during crises. The chart below shows payout ratios since the mid-1980s (overlapped with high-yield bond spreads). It notes that aggregate payout ratios in the high-80%s or higher have occurred only during the most notable economic downturns of the past 30 years. It approached 90% at the end of the long-term debt cycle in Japan in 1989 and during the Russian crisis in 1998. It hit 90% during the dot-com bust and ascended to over 130% in 2008 at the height of the financial crisis. It is back above 100% currently due to five consecutive quarters of falling earnings, including seven consecutive quarters if one goes on a year-over-year basis.
In July 2014, the earnings per share ("EPS") in the S&P 500 was 105.96 based on trailing 12 months' ("TTM") figures, while the S&P 500 stood at 1,930. Today, the S&P 500 stands at 2,160 off just 86.92 in TTM EPS. The buoyancy of the market is most effectively explained by the increase in debt-financed dividends and net buybacks illustrated in the above diagram. (Below, the S&P 500 index is represented by the blue line while the TTM EPS of the index is colored in orange.)
The Intrinsic Value of the S&P 500
Every few weeks, I like to assess an approximate figure for the current intrinsic value of the S&P 500 (NYSEARCA:SPY). I believe that it helps to determine how the current market situation relates to historical norms. Moreover, it can help to back out what type of returns investors are expecting. The model is quite simple, using the market's current earnings yield and dividend yield, a payout ratio that matches with historical expectations (as discussed above), an estimated earnings growth rate, the current 10-year US Treasury yield and equity risk premium as components of the overall discount rate, and a terminal growth rate roughly on par with the long-term expectations of the U.S. economy.
The current earnings yield in the S&P 500 stands at 4.00% based on TTM earnings relative to the current value of the index.
The current dividend yield stands at 2.06% using the same TTM approach, and will be the figure used in the model.
As we observed in the chart above, payouts above 90% are not sustainable long term. Historical norms approximate 74-75%. For the sake of this model, I am going to assume 75%.
Historical earnings growth year over year over the past 10 years has come in at around 4.2-4.3%. On the basis of return on equity, earnings growth comes closer to 4.5-4.7%. For purposes of this model, I am using 4.7%. (Note that earnings growth is different from earnings yield. Yield is TTM EPS divided by the current value of the index. Growth represents the year-over-year increase in the EPS itself.)
The 10-year Treasury is entered at 1.6% to match up with recent price levels. The equity risk premium, or the expected return beyond the risk-free rate to compensate for the greater volatility inherent in the equities market, represents the sensitivity parameter in the model so we can develop a valuation range based on this input. Since 1928, the equity risk premium for the US market has approximated 4.5-4.6% based on the compounded appreciation rate over Treasuries. If we were to use the annual average sum of the S&P 500's earnings yield and dividend yield minus the year-end 10-year Treasury rate (i.e., earnings yield + dividend yield - 10-year Treasury yield), it has come in at 4.1%, which isn't too far off the global rate of 4.0%. Over the past decade in the US alone, it has come to 5.3%, largely due to the fall in Treasury yields.
The terminal growth rate of the US economy is typically taken as 2.0%, as it's a round number and roughly accurate. However, there are arguments that this figure may be lower in the long-term in light of recent central bank policies (e.g., ultra-low rates, quantitative easing) that have taken a lot of growth from the future. Debt has been so cheap that, at the government, corporate, and household level, purchases that would have normally been made at some time in the future have been pushed ahead into the present. Once a point of relative saturation in demand is reached, future economic growth will be compromised to some extent as a consequence of this demand having been pushed forward. At the Federal Reserve's latest policy meeting, not unexpectedly, policymakers dropped the long-term anticipated growth of the economy to 1.8%, down from 2.0%. This 1.8% figure will be used in the model.
The projection is done on the basis of cash flow. We multiply the expected earnings and expected cash payout ratio in a given period (I use a five-year projection) to determine a cash flow for the given year based on the current value of the index. These cash flows are discounted back to the present by dividing it by a denominator term of the sum of the risk-free rate (i.e., 10-year Treasury yield) and equity risk premium to the power of whatever year in the future we are projecting for.
The terminal value is taken as the expected cash flow in the final year of the projection, divided by a discount rate calculated as: 10-year Treasury yield + equity risk premium - expected long-term growth rate of the economy. This terminal value is then discounted back to the present. When added to the present value of the other cash flows, this creates the expected intrinsic value of the index.
Based on these inputs, if the U.S. equities markets were trading off historical equity risk premiums in the 4.1-4.6% range, the S&P 500 would be valued in the 1,920-2,160 range with the fairly buoyant assumption in the annualized earnings growth rate. This would suggest that the market is anywhere from fairly valued to 12.5% overvalued. If we drop earnings growth down to 4.3% annualized, or more in line with historical expectations, this would drop the range down to 1,830-2,070, or 4.3%-18.0% overvaluation. If we assume that earnings growth is going to suffer in step with projected aggregate GDP growth figures by placing it at 4.0% annualized, this places the range at 1,700-1,920, or 10.9%-21.1% overvaluation.
Accordingly, in a bullish case scenario, I have the S&P 500 classified as precisely fairly valued. In a semi-bearish scenario (perhaps more a base case), I have the index over 20% overvalued. Of course, worst-case scenarios, such as a recession, can be much worse.
If we go by 4.3% annual earnings growth, this would suggest that the S&P 500 is implicitly trading at an equity risk premium of just 3.94%, or below historical norms. Naturally, with the mostly yield-devoid savings and fixed income markets, this equity risk premium signifies crowded long trades in the equities market. Based on a 10-year Treasury yield in the 1.5-1.6% vicinity, this gives equities an annualized expected return of approximately 5.5%.
From December 31, 1959, to today, the S&P 500 has yielded 6.52% annualized (adjusted for inflation with dividend reinvestment).
Unless earnings growth manages to rebound or another bout of significant quantitative easing is kicked into high gear somewhere in the world, it may be difficult for the S&P 500 to plow through 2,200 and continue making higher highs. With low rates and quantitative easing sapping yields in savings and fixed income, the implied equity risk premium is low in comparison with historical norms.
Corporations have compensated for the lack of earnings growth through higher-than-average cash payout ratios to keep share prices afloat (particularly debt-fueled buybacks), but these can remain elevated only for so long. In a bullish case scenario (close to 5% annual earnings growth over the next five years), I would expect the market to be trading around where it is currently. In a more bearish scenario (closer to what I'd consider a base case), I would project the market to be around 20% overvalued. A recession could facilitate a more precipitous fall and cause the market to become cheap.
Generating solid returns on US equities is becoming more difficult at these levels for indexed investors who are generally uniformly long and passively trending with the market. That said, it is never a good idea in itself to short an index on convictions of some level of overvaluation. Shorting anything is very difficult to do successfully if there is no catalyst on the horizon that could cause a drop in the market. But I think a strong argument could be made for hedging positions in the current market environment. Over the past few months, I have sold positions I thought had become fairly valued, increased my short exposure in certain companies where I believe a catalyst can be realized, and hedged my remaining longs by buying out-of-the-money put options. While the market may continue to remain at its current level or proceed further upward, with the incentives investors are currently facing due to very unappealing savings and fixed income yields, achieving quality returns can become more elusive when market valuations begin to stretch outside of their underlying fundamentals.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.