Some investors like to use index levels to measure the valuation of the market. I prefer using share prices on ETFs that track the index. Therefore, you won't hear me talking about the level of the S&P 500, but I will reference the share price of the SPDR S&P 500 Trust ETF (NYSEARCA:SPY). The reason I prefer to use the ETF rather than the index is because the ETF is very "investable". I could always buy shares of SPY, and I can always measure precisely the return that would've been generated by that investment. Of course, an investor can also look at the history of the index level, but I can grab dividend adjusted close values in about 10 to 20 seconds to find returns on SPY from any point to any other point and compare it to any other investment.
Simple Round Numbers
I could have used $224.93 for this piece and the underlying analysis would've been the same. However, I think round numbers are much easier to remember and thus more practical to use.
Implications If SPY Hits 225 - Capital Expenditures
As the S&P 500 rallied dramatically since the last recession, there was a huge amount of capital spent on share buybacks and dividends. Neither is an "expense" under GAAP, but both are a major use of capital. When the Federal Reserve started hammering away on interest rates, it was able to make debt fairly cheap. The idea behind cheap debt is that it reduces the WACC (weighted average cost of capital) for corporations. A lower WACC, at least in theory, means more of the potential investments a corporation can make should yield a high enough IRR (internal rate of return) to justify the expenditure. While the Federal Reserve can't do much to increase the sales the business would have, the lower interest rate on debt should still make projects acceptable if they were almost good enough prior to the low rates.
It didn't happen. The S&P 500 continued to have weak capital expenditures and took on cheap debt so it could repurchase shares. That drove earnings per share higher and was very favorable for shareholders, but it didn't fix the issue of weak capital expenditures. The following chart demonstrates the uses of corporate cash by year:
As the S&P 500 climbs higher, the earnings yield, dividend yield, and cash flow yields all grow weaker. Repurchasing shares when those yields are exceptionally weak is a very poor strategy to grow the "per share" metrics for shareholders. High share prices demand that the company find a better use for capital than repurchasing shares. When Wal-Mart (NYSE:WMT) trades around 14x earnings and Target (NYSE:TGT) trades around 13x earnings, they can both repurchase shares to drive returns for shareholders. When Apple (NASDAQ:AAPL) trades at levels that are even cheaper, it can certainly attempt to repurchase shares as a way to drive value, but unlike WMT and TGT, there is more concern about AAPL's products simply falling off. I can stop using AAPL products, but I can't stop eating groceries.
The reason a high index level should be favorable for capital expenditures is because several other companies are trading at 20 times, 25 times, or even 30 to 40 times earnings. Those huge earnings multiples demand strong growth and repurchasing shares won't get the job done. I can still see repurchasing shares at 20 times earnings and cash flows, but at 30 it gets absurd.
Unfortunately, I must point out that high index levels in the past have not indicated a strong shift to capital expenditures. Leading up to the last financial crisis, the amount of cash used to invest for growth was falling and the amount going into dividends and buybacks was higher. The absurdity of buying back shares at high multiples is not necessarily clear to the executives making the decision.
Implications If SPY Hits 225 - Defensive Investors Fall Behind
I consider myself a defensive investor. I'm happy to include some index funds in my portfolio, but I also put heavier weights on dividend champions that have low correlations with the market and trade at lower multiples (and higher dividend yields). I put a material amount of capital into buying preferred shares. Sometimes those are short-term trading positions based on providing liquidity to an illiquid market, and sometimes they are long-term holding positions where I'm simply happy to collect a 6% to 9% yield.
At least up until the start of June, my portfolio was beating SPY by 2.5% on the year. I was up on the index despite often having significant cash allocations. On a risk-adjusted basis, I think my returns were materially better than SPY. If SPY ends the year under 210, I expect to beat the index thoroughly. If it ends the year around 218, I would simply need to remain flat over the next seven months to get a tie. If it ends around 225, my odds of beating it get weaker. As of early June, my returns on the year were 9.072%. The early part of June has been good for the S&P 500, but I ended up with a fairly strong rally and gained almost 2% during the short period. That's not too bad for a portfolio emphasizing preferred shares and defensive stocks. Over the last couple days, I've seen both SPY and my portfolio take a hit. The surprising thing to me is that the 10-year treasury rate was falling. My portfolio suffered a little bit more than the S&P 500 despite my emphasis on assets that should benefit from lower treasury rates.
Investors have to decide how aggressive they want their portfolio to be and how they want to measure their portfolio. I believe it is imperative that each investor make that decision and stick to it. Changing strategies and becoming more aggressive in a bid to keep up with the S&P 500 after a large rally has happened is a recipe for disaster. The same can be said for deciding to be much more defensive after a large fall.
Beware The Federal Reserve
It seems to me that the Federal Reserve may believe that its dual mandate has been expanded to include managing the level of the major equity indexes. To avoid a potential crash in share prices down the road, it may try to scare the market into lower prices today. Smaller drops that keep the level of the index within a range of 15% or so may be seen as less dangerous than allowing it to build to a level where it could reasonably fall 20% to 30%.
For the domestic economy to see higher levels of capital expenditures that would drive real growth in the economy, it may be necessary for the S&P 500 index to trade at high valuations, so that fewer companies can deliver strong growth through simply buying back shares. If we see prices setting new record highs, it will be difficult for defensive investors to keep up, and it would be very dangerous for them to change their strategy.
While high price levels could eventually encourage capital expenditures, the Federal Reserve may be scared of the risk for a large fall in equity. To manage the risk of index levels getting too high, it may become increasingly aggressive. An exceptionally high index level relies on investor confidence, so the fundamentals don't have to change for prices to swing.
Disclosure: I am/we are long TGT, WMT.
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.
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