For this month's S&P 500 (NYSEARCA:SPY) valuation edition I've decided to shorten things up and get more to the point. Last month's edition was 3,000-4,000 words and there seemed to be some level of confusion in the comments section. I believe this stemmed from either philosophical discrepancies over the mechanics of how a market moves or is valued. Or else the length generated too much skimming (which I don't blame them) and resulted in some belief that I was putting forward some "black box" type model instead.
I value the market based on discounted cash flow, which is fundamentally how equity markets are valued. There is emotion and there are human biases, but at the most fundamental level it boils down to how much cash you can take from a business - or set of businesses in the case of an index contoured to the specification of the index's weighting - discounted back to the present.
Markets price where they do because of the underlying assumptions governing them. A lot of what happens in the market, and how you "win" at investing or trading in general, is by correctly predicting how events will transpire relative to their embedded expectations.
So there are inherent beliefs built into the market regarding growth rates, both near-term expectations (what earnings will do the next quarter, year, five years, etc.) and growth expectations that cover more of a multi-decade time horizon (i.e., long-term economic growth rate).
I do this exercise for two main purposes:
1. To back out what kind of forward returns expectations the market might be currently baking in.
2. To determine what kind of earnings growth expectations the market might be assuming.
These models are simple and only depend on a few main factors:
For this edition, I used the following inputs from the market as they stood as of the market close on April 28, 2017, the last trading day of the month:
- 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., expected returns minus the 10-year Treasury yield)
- Perpetual growth rate, set equal to the long-term real growth expectations of the US economy (currently 1.8%)
The current dividend yield in the market is 1.95% and has hung around the 2% mark for roughly the past 15 years in the market's history.
The earnings yield stands at 3.97%, which is a 20-bp improvement over last month with the earnings results that have come in over the past month.
Historically, this yield is still low. It factors in that prices remain ahead of earnings on expectation of an expansion in future quarters as a result of corporate tax cuts and also deregulatory initiatives for certain sectors of the economy. An infrastructure bill would also be welcomed by the market but is unlikely to get done in the near term.
Cash payout ratio
A cash payout ratio of 80% is something I've normally held constant as an assumption over the past several months. During the earnings recession from Q1 2015 to Q3 2016 (when measured year-over-year), the payout ratio had hovered above 100% as companies created market demand for their shares by buying them back.
Private non-residential fixed investment (also known as "business investment" more generically) has also been low, but received a 4.0% year-over-year increase when Q1 GDP came out last Friday. This was the largest increase observed in eight quarters, back when earnings began decreasing in year-over-year terms.
(Source: St. Louis Federal Reserve)
Cash payout ratios have hung around 75% historically and the uptick in business investment could be a sign that payout ratios will renormalize with buybacks becoming less prominent in favor of corporations plowing back more funds into organic growth initiatives.
Interest rates are also increasing on shorter-term debt maturities given the US Federal Reserve is actively in a tightening cycle with respect to its monetary policy. Combined with the fact that the aggregate market is trading 0.5% off all-time highs, this makes debt-fueled share repurchases less attractive. However, for now, I'm leaving the cash payout ratio at 80%.
Earnings growth rate
Based on the historical average spread between Treasuries and stocks (roughly 4.1%), this would back out an earnings growth rate of 9.67% over the next five years in order to match the current value of the index. This is down from 11-12% at the beginning of March, now that the value of the index is slightly lower and some level of earnings growth is occurring, continuing on from Q4 2016.
I use this input as a sensitivity parameter, which I'll run through in one of the valuation scenarios in the results section below.
10-year US Treasury yield
Recently, the 10-year and stocks have trended in the same direction, which is positive for the equities market overall. Bonds and equities continually compete for fund flows. The higher the 10-year yield gets, the more likely it will be that investors will begin to push more of their capital into bonds instead of stocks, as risk-adjusted returns become more attractive with respect to the former.
This was one of my primary arguments against the notion that the 10-year would rise into the upper 2% range. If it did rise to 2.7-2.8% this would be a material headwind to further appreciation in stocks. Investors are largely onboard with the idea that forward returns expectations of equities are lower relative to historical standards. Therefore, even though the 10-year yield is still around historical lows, there will continue to be demand for Treasuries at their elevated prices given the frothy situation in the stock market.
Currently, the 10-year is hanging around a 2.3% yield.
Equity risk premium
This is equal to the earnings yield plus the dividend yield minus the 10-year Treasury yield. This can be entered in as a sensitivity parameter when using a certain earnings growth figure to back out the types of forward returns expectations the market might be pricing in, equal to the equity risk premium plus the 10-year minus inflation.
It's naturally difficult to get a feel for how the implicit 9.67% y/y forward earnings growth rate is in terms of likelihood. Some of this will depend on how the fiscal policy picture turns out and how soon. Earnings are also inherently volatile from year to year, much more so than the underlying economic growth rate.
A 6-10% y/y earnings growth rate would price the market in a range of 2,040-2,420, which would suggest anywhere from a 17% overvaluation to a 1-2% undervaluation.
If we were to take the midpoint of this range (8%), this would back out an equity risk premium of 3.79%. To find forward real returns, we need to add the 10-year Treasury yield and subtract inflation. With the 10-year at 2.28% and 10-year breakeven inflation at 1.91%, this would suggest forward annualized real returns equal to 4.1-4.2% or roughly 6% better than staying in cash, including inflation.
The following chart displays forward returns expectations if the following year-over-year earnings growth rates were implied in the current price of the S&P 500 index:
Based on where we are with bond prices - still among all-time highs in both absolute terms and the basis point spread with respect to Treasuries - it's logical to suspect that 6-10% y/y earnings growth is the logical assumption in the market currently and forward real returns are right around 4%.
However, will the market, at this stage in its development, be able to produce close to 10% in annual earnings growth?
Since Q1 1990, we've averaged only 7.51% in earnings growth. Part of this figure was marred by a historically bad down-cycle from Q3 2006 to Q4 2008, which saw a 52.3% drop in corporate earnings. Still, with slowing innovation and demographic headwinds as time progresses, achieving and surpassing what was done in the past when long-run annualized real growth expectations were 0.5-1.0% higher will become more difficult.
Matching the earnings growth rate from the past 27 years would put forward real returns at 4.1%.
Is the market expensive? It's difficult to say as there's a lot in flux on the fiscal policy front. A tax plan likely requires some level of Democratic support. Republicans can hope to pass tax reform through reconciliation (an expedited process that requires a simple majority) if they can coalesce around a certain bill, but that process is subject to certain restrictions. Nothing is likely to get done on infrastructure for the time being.
The implied earnings growth rate of close to 10% would materially run above the rate we've seen since Q1 1990, but would be doable if tax cuts and deregulatory initiatives are able to expand corporate bottom lines. Over the next decade-plus, it's very likely that economic growth will underperform the 2.4% y/y rate we've seen since this date, but it's feasible for business profits to outperform if the environment becomes more favorable.
Matching the earnings growth history since Q1 1990 under standard risk-taking behavior would put the value of the market at around only 2,170. This implies the market is betting on something more.
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.