There is an intense focus on GDP growth and corporate earnings as the current business cycle matures. On-going debt problems in Europe and a slowdown in emerging markets brings to question the ability of companies to continue their torrid profit growth of the last two years. In addition, both leading and lagging economic indicators point to a slowing of growth in the US, and an outright contraction in the EU. What does all this mean for the stock market? Not much.
The market is trading at around a 7.5% earnings yield. By itself this is an unremarkable number. Taken in context, it is an unprecedented yield relative to cash, commodities, and especially bonds. The ten-year treasury yield is now pushing below 1.4%. The current spread between the ten-year treasury and the earnings yield is over 6%. The last time this happened, in 1974, the market rallied 51% over the next two years, after having dropped a cumulative 47% in 1973 and 1974. However, the abnormally low ten-year treasury must be considered before assuming that a 7.5% earnings yield alone is a reason to buy.
Normalized Interest Rate
Calculating the inflation rate as the difference between nominal and real GDP going back to 1960 (i.e., the GDP deflator), the average inflation rate between 1960 and 2007 was 3.86%. Subtracting that from the average yield on the ten-year over the same period gives a real return of 2.96%. Paltry, but palatable considering that today the real return is negative. Assuming Real U.S. GDP grows at a 1.5% rate this year, a normalized ten-year yield would be around 4.5%. At this yield, the equity risk premium would be 3% today. Since 1960, the equity risk premium has averaged .41%, and prior to 2008 had only been above 3% in the years 1974, 1977 and 1978, when rapid increases in inflation pushed the earnings yield much higher. The equity risk premium has been positive 53% of the time and negative 47% of the time since 1960.
The current dividend yield on the S&P 500 is 2%, and more importantly, the payout ratio is 27%, which is the absolute lowest it has been in over 50 years. As recently as 1991, the payout ratio was 67% and has averaged 45% since 1960. Over that time period, dividends have been increased at an average rate of 5.38% annually. In 2011, dividends on the S&P 500 were increased 12.5%.
Global GDP Growth
By IMF estimates, real global GDP will grow 3.5% this year, and inflation will average 2% in developed economies and 6.3% in emerging economies. The World Bank estimates that global GDP was $70 Trillion in 2011, which means that if global GDP growth forecasts are accurate, and additional $5 Trillion will be added to aggregate economic output this year. S&P 500 companies generate 45% of their revenues from outside of the U.S., and less than 15% from Europe. Assuming there is a mild contraction in the EU, slow growth in the U.S. and a slight pickup of growth in emerging markets, GDP growth as seen by S&P 500 companies will be in the range of 2 to 3%. Historically, that is sufficient to generate continued profit growth. Real GDP growth has averaged 3.1% since 1960 in the U.S., and 3% globally since 1969.
Currencies and Interest Rates
In this world of competitive devaluations, we will likely see a continued race to the bottom for developed market currencies. However, emerging economies have less room to loosen monetary policy relative to their developed markets peers. This global rebalancing of accounts will take several more years to play out, and the benefit will go to established multinationals with excess capacity and a cheap source of capital.
Profit Margins and Earnings
So far this year, corporate profits have proved resilient. This may change, but what ultimately matters for stock prices are earnings per share. With excess cash on their balance sheets, cheap borrowing rates, low debt levels, and a lack of investment requirements, companies will continue to buy back stock or do acquisitions, both of which are accretive to earnings. Companies have clean balance sheets and a control on operating costs, which should support continued expansion of the business cycle that started in 2009.
The ratio of S&P 500 earnings per share to billions of dollars of nominal GDP has averaged .52% over the last 50 years, with a maximum of .74% in 1965 and a minimum of .32% in 1991. The current ratio is .64%, which is well within the historical range. Considering the increase in revenue generation from outside of the U.S. over the last decade from 30% to 45%, one could argue that this ratio can stand to be much higher.
Even if earnings per share do drop, that itself is not an indicator of where the market will go next. Over the last 50 years, earnings per share have fallen twelve times, and the market has fallen concurrently three times, and twice in the subsequent year. In six of the twelve years, the market fell the year prior to the earnings drop. Contrary to popular belief, the market does not always fall in advance of earnings (or vice versa), and historically has done so only 50% of the time.
Years that S&P 500 Earnings Declined (1960 - 2011)
Years that S&P 500 Index Declined (1960 - 2011)
There are real economic problems globally. There always has been and always will be. However, this time is no different. Global economic output will continue to expand, companies will continue to find new markets, trade barriers will continue to fall, and people will continue to demand higher standards of living. The excessive bearishness is overdone. Europe might implode. Iran might explode. China might crash. The US might fall of a cliff. These are all hypothetical scenarios that are well known and have been analyzed to death.
There is the potential for policy makers to surprise the market, which could lead to a significant upside move. Assuming that does not happen, the downsides have mostly been priced in, including many of the negatives listed above. Valuations are undemanding historically and relative to other asset classes, which should provide a decent floor to the market. I expect the S&P to trade in a range of 1250 to 1400 for the next several months, with the potential for a breakout sometime after the election.