The US equities market, as represented by the S&P 500 index, as a whole is probably overvalued by double-digit percentage points based on over-optimistic earnings growth expectations. But there is no immediate catalyst to reprice the market.
Once per month I attempt to determine the intrinsic value of the US stock market using a discounted cash flow model by incorporating the basic statistical elements that work into determining its value. This better helps determine how current valuations compare historically and project the kind of forward returns expectations we might currently be looking at.
Since its launch on March 4, 1957 (at a value of 43.73), the S&P 500 has become the most widely followed stock index the world. I also prefer to use the S&P 500 (NYSEARCA:SPY) as the proxy for the US stock market given its weighting by market capitalization (i.e., more valuable companies take up more of the index) and inherent sectoral diversification (top 500 companies by market capitalization).
About 80% of all available market cap in the US is wrapped up in this index.
Spreads between "risk-free" and risk assets have recently approached cyclical lows, which suggests that equity prices - and prices of risk assets generally - are getting fairly lofty. Various examples include the spread between the 10-year US Treasury and emerging market debt, 10-year and high-yield, and the equity risk premium in stocks.
(Source: St. Louis Federal Reserve)
On the basis of earnings…
Basic earnings multiples analysis suggests stocks are the most expensive they've been since the dot-com bubble. (I don't count the 2008 spike given that was caused by the extreme drop in earnings.)
The CAPE ratio developed by Yale professor Robert Shiller implies stocks are the third-most expensive ever, just behind 1929 valuations and 52% off the all-time highs of 44.2x in December 1999.
However, stocks are not 68%-72% overvalued when comparing today's earnings multiples relative to historical averages.
Accommodative monetary policies throughout the developed world since the financial crisis have lowered interest rates, which has consequently led to lower rates at which the market's cash flows are discounted. This has, in turn, pushed up prices. So long as interest rates remain lower for longer, stocks will continue to trade at elevated earnings multiples relative to historical standards moving forward.
On the basis of discounted cash flow…
I do this exercise not to assert precisely what the S&P 500 should be valued at, as different individuals will price the market differently based on their returns expectations. For someone expecting 10% nominal forward annualized returns, the market is probably vastly overvalued. For someone expecting 6% nominal forward returns, current prices might be more agreeable.
For the discounted cash flow model used in this article, I use the following inputs from the market as they stood as of market-close on March 31, 2017:
- Current dividend yield
- Current earnings yield
- Expected cash payout ratio (the sum of dividends and net share buybacks as a percentage of earnings)
- Earnings growth rate
- 10-year US Treasury yield (used as a risk-free rate)
- Equity risk premium (i.e., investors expected returns minus the 10-year Treasury)
- Perpetual growth rate, set equal to the long-term real growth expectations of the US economy
- Dividend Yield
As of March 31, the current dividend yield of the market comes to 1.93%, up 3 bps over last month. The S&P 500 reached an all-time high on March 1 (roughly 2,396) and is down 1.4% from that mark at 2,363, which helps account for the increase. This dividend yield figure is calculated by taking average dividends on a trailing-twelve-months' ("TTM") basis and dividing the amount by the current value of the index.
Sub-2% levels been more or less the norm for the past twenty years.
- Earnings Yield
The earnings yield of the S&P 500 is currently at 3.77%, up 6 bps since last month. This is trending near lows not seen since late-2009. It is also the third-lowest on record behind the 2008-09 financial crisis period and from the late-90s/early-00s during the dot-com boom.
This earnings yield value comes from the same TTM approach and will be the figure entered into the discounted cash flow model. This figure is down 40 bps from where it was back in December, mostly attributed to the rise of the stock market in expectations of tax cuts, deregulatory initiatives, and possibly infrastructure spending, all of which investors anticipate will provide a fiscal boost.
This yield is expected to increase in the quarters ahead as the market begins to "grow into" the earnings the market is currently pricing in.
- Cash Payout Ratio
The cash payout ratio in the market has been above historical norms since corporate earnings peaked in late-2014. To counter the seven-quarter earnings recession (when measured year-over-year) that ended in Q4 2016, management teams have bought back stock in large quantities to keep earnings per share elevated and investors on board. This has been especially true given how cheap debt has been.
Payout ratios above 100% of earnings are unsustainable and it's rare as a whole to see them elevated for larger periods of time. This is the first time in recent history that we've seen 100%+ payout ratios outside of market crises (unless one wants to consider an earnings recession a crisis in itself, though it isn't credit-related). And we're currently seeing payout ratios in excess of those observed during Japan's credit crunch in 1989, the Russian crisis in 1998, and the dot-com bubble of 1999-2000.
Overall, the payout ratio should run around 80% or lower long-term. The historical rate has hovered around 75%. REITs, which are legally obligated to payout 90% to maintain their legal status as such, generally only find the ability to do so by issuing equity capital and diluting existing shareholders. Business growth requires reinvestment, which generally means plowing back under 20% of earnings into various corporate needs is difficult while still being able to observe sufficient business growth.
With that said, valuations are time-sensitive. Equity markets are fundamentally valued by the present value of the cash that can be extracted from the companies that comprise the given index, in accordance with its weighting specifications. Accordingly, higher payout ratios can validate a higher reading for the market as a whole.
A steady, equivalent stream of cash flows discounted back at 7% will have 30% of its present value wrapped up in the first five years. And if payout ratios are going to remain higher as a percentage of earnings over the next 1-3 years, this will have a material impact on equity valuations.
Private non-residential fixed investment recently came out of a four-quarter recession, measured year-over-year.
(Source: Federal Reserve Bank of St. Louis)
This means many businesses have not found many viable projects in which to invest, which means more capital has been pushed toward buying back equity as the best move in terms of ROI. These higher payout ratios could remain in place over the short-term if private non-residential fixed investment growth remains low, mainly as a consequence of a continuation of lower global demand. Thus, as mentioned, a continuation of higher payout ratios could be justified in the short-run if fixed investment growth remains underwhelming.
In the discounted cash flow model used for this exercise, I've set the cash payout ratio to 80%, a rate that is sustainable yet still above-trend, though it could run higher in the short-term.
I find that each 5% increase in the payout ratio tends to increase the value of the market by 6%-7%, given these funds by definition go back to shareholders (but at the expanse of lower organic growth moving forward).
- Earnings Growth
Earnings growth is the most important part of the equation as this is the central basis off which stocks trade. Earnings are quite volatile and difficult to predict year to year. As aforementioned, earnings were formerly negative for seven consecutive quarters measured year-over-year from Q1 2015-Q3 2016, but recently recover to a 3% y/y figure in Q4 2016. Q1 2017's earnings will shed more insight into how corporate prospects are progressing as we get into April.
The 11% rise in US equities since the November elections have priced in some level of tax cuts and deregulation being pushed through. The expectation is that these measures will not only provide a basic boost to earnings but also incentivize the onshoring of more business activity by balancing the corporate tax landscape with that of other developed nations.
Earnings growth has roughly approximated 8% as a median figure, a period of time which includes the high level of innovation during the mid-to-late 1990s but also two major busts in the dot-com crash and financial crisis. Earnings growth will serve as an input that's sensitized over a range spanning from 0%-15%. For purposes of providing a forward-five-years estimate, I use the same 8% number.
- 10-Year Treasury Rate
The 10-year Treasury rate has been hanging around the 2.30-2.60% mark and is at 2.40% at the time of this writing. I'm not a big believer in the "short Treasuries" trade that's a very common position in the industry currently and overall I expect the 10-year yield to remain relatively range-bound for the next several months.
A higher 10-year Treasury (i.e., lower yields) is positive for stocks. The 10-year Treasury rate is among the most followed financial variables followed globally and has a hand in pricing trillions of dollars worth of other fixed-income assets. If 10-year yields remain low, this encourages more capital to remain in risk assets on a flow of funds basis, as the risk-adjusted return may be deemed better by staying long equities. In terms of corporate finance basics, lower Treasury yields work to keep discount rates compressed and therefore increase valuations.
In the US, the 10-year yield is at about 60 bps above the economy's expected long-term growth rate. In terms of investor behavior, higher bond yields without a simultaneous increase in growth will create higher returns expectations for stocks.
At the same time, equity values are not purely mechanical and much relies on investors' risk appetite. Hence a large part of valuations is contingent on the level of risk aversion in the market, which brings us to the model's input of the equity risk premium.
- Equity Risk Premium
The equity risk premium helps to back out the forward returns expectations in the market. It is defined as the annual average of the S&P 500's returns (i.e., earnings yield plus dividend yield) minus the year-end 10-year Treasury yield. This has historically trended around 4.1%. This means that investors on average expect around 4% extra return on stocks in order to compensate them for the extra volatility they take on.
As mentioned, this exercise is done by projecting a series of cash flows and discounting them back to the present. To do so, we need to take (1) the current value of the index, (2) the expected earnings yield, and (3) the expected payout ratio, and multiply them together. This provides the amount of cash is being released to shareholders in year one.
This is completed for each year of the projection period, using the earnings growth rate chosen to fill out the remainder.
These cash flows are discounted back to the present by using a discount rate equal to the sum of the equity risk premium and the 10-year Treasury yield taken to the power of whatever year in the future we're estimating.
After the projection period, a terminal value is calculated. This would essentially be the expected cash flow in what would be a sixth year, calculated by taking the earnings projected in year five and multiplied by the long-term growth rate of the economy (1.8%, per the Fed's estimation, which is likely pretty accurate). This figure is then divided by a discount rate equal to: 10-year Treasury yield + equity risk premium - the expected perpetual growth rate of the economy
This terminal value is then added to the present value of the cash flows derived in the projection period to obtain a value for the index.
Using this discount rate, the terminal value calculation can then be discounted back to the present. This value is then added to the present value of the other cash flows to obtain an intrinsic value for the index.
If we use the historical equity risk premium of 4.1% and a payout ratio of 80% (base assumptions), and we adjust growth expectations by +/- 150 bps on each side of the 8% figure mentioned above, we would obtain a valuation of the S&P 500 index at 1,910-2,170 (2,040 median), which would place it at an overvaluation of 11%-24%.
If we change some of these assumption to reflect a more bullish stance, we can try the following:
- upping the long-run growth rate to 2.0% (from 1.8%)
- increasing the cash payout ratio up to 85% (from 80%) per the line of discussion above
- discount at an equity risk premium of 4.0% (down from 4.1% to reflect greater risk appetite)
- increase the earnings growth to 10% year-over-year for the next five years
This would place the index at a valuation of precisely 2,500, which would represent another 5%-6% leg up.
Investors Returns Expectations
If we were to sensitize the current value of the index to the equity risk premium using our base assumptions, it comes in at just 3.46%.
The 3.46% figure is 50 bps lower than the figure calculated from late September and 35 bps lower than the pre-election figure. This is a very large difference and illustrates the level of confidence that the market is putting into stocks at the moment from a combination of future expansionary fiscal policies and accommodative central bank policies. Real interest rates are negative at somewhere between -1.8% and -1.2%, depending on whether you use the 2.7% headline inflation rate or 2.1% PCEPI inflation (the Fed's preferred measure), and taking into account a 0.875% effective federal funds rate.
In terms of historical annualized, from February 5, 1971 (the first day the S&P 500, Dow Jones (NYSEARCA:DIA), and NASDAQ (NASDAQ:QQQ) traded simultaneously), the S&P has yielded 7.17% annualized; the Dow Jones has yielded 7.06%, and the NASDAQ 9.25%.
These figures are inflation-adjusted and consider dividend reinvestment.
At a 10-year yield of 2.40% and with core inflation at 2.1%, this would suggest about 3.7%-3.8% in real returns moving ahead (2.40% Treasury + 3.46% equity risk premium - 2.1% inflation).
If we were to assume 12% year-over-year earnings growth over the next five years (i.e., earnings would be 76% higher in April 2022 than they are currently), as many are pricing in, this would produce an equity risk premium of 4.2%, which would generate forward real returns expectations of approximately 4.5%.
If using base assumptions of a 4.1% equity risk premium and a payout ratio of 80% and the index's valuation is sensitized to earnings growth rates ranging from 0.00%-20.00% in increments of 250 bps, the numbers would return as follows:
This implies year-over-year earnings growth expectations are fairly high, right around the 12% y/y figure mentioned above.
Tax cuts and certain deregulatory moves can help achieve this. But at the same time, this pace of earnings growth would clearly be above-trend relative to where the US is in its economic development, with demographic headwinds and slowing innovation. It will be difficult for US equities to return 7% or above in real terms moving ahead as they have over the past ~50 years. With the market at its current price point and pricing in earnings growth at around a 11%-12% y/y figure, equities are still expected to return 2.5%-3% lower per year than their historical norms going forward.
This means even with bullish assumptions, the US equities market is very crowded on the long side and provides relatively poor risk-to-reward as a whole. Then again, with bond yields remaining relatively poor as well, many investors believe that they don't really have any other viable alternative than to remain in stocks.
Based on historical earnings multiples, the market will naturally look very pricey. But this is distorted by the fact that modern central bank policies in developed economies have forced valuations higher by pushing investors out over the risk curve to attain yield. Interest rates will remain lower overall than they have been in the past due to lower lending demand, which will directly support stocks trading at higher earnings multiples than they have in the past.
If earnings attain a figure of 8% y/y growth over the next five years (in line with the previous 27 years) with a historical-average risk appetite (4.1% equity risk premium) and above-average 80% cash payout ratio, this would value the S&P 500 at 2,040, for about a 16% overvaluation.
This would place earnings multiples at 19x-20x and be about 35% above historical averages. It would also suggest 3.7%-3.8% in forward real returns. Even with hyper-bullish assumptions - e.g., 15% y/y earnings growth over the next five years - this would only suggest about 5.1% in forward annualized real returns.
Sub-4% real forward returns are not attractive, but at least offer the opportunity of around 6% in nominal returns. Although equities are volatile, no other asset class is very likely to provide that type of return even over the medium-term, so the TINA principle (there is no alternative) continues to hold.
I do believe stock valuations are stretched, but this is not to be taken as an outright "bear" argument. Rather, I simply think stocks as a whole don't provide very compelling value. There is no real catalyst for a repricing of equities from their current levels. March was a fairly boring month, with the index not moving much in either direction, and losing about 1.4% of its value in the end. What Congress is able to accomplish (or not accomplish) on the issue of tax cuts will be a market mover over the coming months.
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.