Monthly update of the intrinsic value of the S&P 500 using earnings and discount rates. The goal is to determine an approximate level of future nominal returns expectations and current risk tolerance in the market. Basic Idea Stock prices are a function of earnings (cash flows) and making discount calculations using capital costs to add up their present values. Market-wide stock returns are a function of a beta – a return in excess of a substitute asset, such as a “risk-free” cash rate or some type of bond that’s considered guaranteed – plus the present yield of the yield of whatever asset is used to calculate the beta. In terms of the raw economic components, stock returns are a function of real economic growth, inflation, any net contribution from dividends/buybacks, and fluctuations outside of this trend associated with changes in the present value calculation. Economic Backdrop 2017 was amenable to stock valuations as economic growth remained above trend and credit costs remained muted outside of a few hikes in the front end of the curve. Earnings growth and the stability in credit costs were both underpriced leading to a blow out year. 2018 isn’t shaping up the same way as credit tightening is becoming more of a drag on asset prices from multiple angles. 1. The US economy is getting closer to its capacity constraints, which makes inflation fears and rising rates more of a concern, hence the increased volatility in equity markets. Skilled labor markets are relatively tight, though unskilled labor markets still have a lot of slack and a lot of potential workers are still on the sidelines. 2. Oil demand is outpacing oil supply. As a central input into corporate cost structures (and heavily passed off to consumers), this triggers higher inflation expectations. 3. Higher deficits mean higher credit funding costs, holding all else equal, as debt rises relative to output. This increases rates and diverts cash from productive consumption and investment outlets toward debt servicing. Inflation and inflation expectations are the primary determinants of credit costs, but deficits are increasingly becoming more influential. Deficit spending can be beneficial if it helps increase the efficiency of the labor force or increase the productive capacity of the economy. But this is not the case and mostly goes toward non-productive outlets in the form of Social Security, Medicare and Medicaid, which comprise approximately 60% of the US budget. Government deficits are too large and already materially crowd out more efficient uses of the funds by the private sector. This produces a gradual squeeze over time. What This Valuation Model Represents Valuations are a measure of risk and don’t drive the market themselves. Capital flows drive markets and the control over the money and credit creating capacity of the economy lies predominantly in the hands of the Federal Reserve, particularly if we’re talking about US markets. And capital flows are mostly credit, not money itself. In the US, money (i.e., currency and reserves) is approximately $3.8 trillion versus roughly $70 trillion in credit. Money settles transactions while credit is a future promise to pay. Cyclical ebbs and flows in equity markets are largely due to the expansion and contraction in credit. Valuations tell you where the market could go if a catalyst enters the picture to change the trajectory of a market. Earnings and sales are important at the individual stock level. The type of modeling done in this post explains what type of returns you can expect from stocks over a multi-decade period. Thus it is not meant to be interpreted as a short-term predictor of where US stocks will go. Variables To do this valuation exercise we need the following: - Current value of the index - Earnings yield - Dividend yield - Cash payout ratio (i.e., what percent of earnings are paid back to shareholders) - Expected earnings growth rate - Current risk-free rate - Equity risk premium (i.e., how much more yield do investors expect out of stocks versus a safe asset) - Long-run economic growth expectations - Long-run inflation expectations The earnings yield of the index is approximately 4.00% on a trailing-twelve-months basis. Cash payout ratio can be assumed at about 80%. Historically it’s trended at about 75% but a dearth of viable investments and low earnings relative to historical norms has pushed this higher in recent years to help keep shareholders onboard. In terms of a long-run growth rate, financial assets can’t perform beyond their earnings growth indefinitely. Accordingly, we should expect stocks to yield at about the long-run growth rate of the economy – approximately 3.5%-4.0% – using some combination of 1.7%-2.0% growth and 1.7%-2.0% inflation. The risk-free rate is debatable. Many use the 10-year US Treasury as a convenient safe benchmark. This is fine if your holding period is 10 or more years, at which point the 10-year yield can be considered your cash rate. But the 10-year is a relatively volatile instrument (about half that of US stocks), so for someone who wants to stay freely liquid without risking capital losses, a better “risk-free” proxy would be the 3-month US Treasury bill. Three-month Treasuries have a daily standard deviation of 0.04% (compared to 1.2%-1.3% for US stocks), leaving it as essentially a pure cash rate. Using the return on cash itself makes intuitive sense because people mainly invest their money to earn an excess return on whatever they could get by simply holding these funds in a savings account, where they could be fully withdrawn at any point. For this reason, I prefer a 3-month Treasury. It’s currently trading at 1.85% as of the time of writing, which roughly accords with the best savings rates for USD-denominated accounts. The equity risk premium (ERP) is something that can be sensitized over a range. This reflects a discount rate or a returns expectation in the market. If the ERP is 5.0%, for example, then this assumes investors expect a 5.0% return above that of cash. At a 1.85% return on cash, that’s 6.85% in nominal returns, or a little under 5% in real terms assuming 2% inflation related to the basket of goods that the Fed measures year-over-year price gains. For long-run growth expectations I use 1.8%, which accords with the US Federal Reserve’s expectations and 2.17% for inflation over the next ten years to keep in line with market expectations. This comes to a 3.97% nominal growth rate. Valuation If we run these assumptions over a wide ERP (i.e., nominal returns expectations over cash) range of 4.5%-6.5% (6.35%-8.35% forward nominal returns expectations), then we get valuations going from 1,970 to 3,620 for an intrinsic value. At 5.0%-6.0% (6.85%-7.85% forward nominal returns expectations), a range of 2,230 to 3,000. The graph a few paragraphs below represents a pricing curve based on various required rates of return. Investors with higher returns expectations will price the index lower than those with lower returns expectations. A 5.5% ERP (or 7.35% nominal returns expectations) would place the value of the index at 2,550, which is 3%-4% where we are currently. If one were to require 7% nominal forward returns, that would put its value at 2,850, or about 8% above its current level. If we were to back out a value based on the current mark of the index by adjusting the equity risk premium, we’d get an ERP of 5.37% – 2 bps lower than last month when this exercise was run, but 14 bps lower over two months ago. This would come to 7.22% forward nominal returns expectations. This is 18 bps better than last month. This comes to about 5.05% in real terms using 10-year breakeven inflation expectations, up 12 bps from last month, and up 16 bps from two months ago. In other words, US stocks are looking more attractive than they were relative to previous months. The following graph shows valuation levels of the S&P 500 at various risk premiums – i.e., expected returns above that of cash. Year-over-year earnings growth is set equal to a 3.97% assumed long-run level (combination of 1.80% real growth and 2.17% inflation), but this will also be sensitized from 3.0% to 4.5%. We are currently between a 5.25%-5.50% return over cash with stocks priced where they are currently. Expect this number to continually contract as the Fed tightens monetary policy. As this number contracts, it means the risk to holding stocks increases. Namely, you’re obtaining less return (over a safe asset) per each unit of risk. The graph below shows valuation levels of the S&P 500 using 7% forward nominal returns expectations and forward long-run nominal growth ranging from 3.00%-4.50%, at 25-bp increments. Bearish projections of long-run economic activity would discount the S&P’s fair value back to 2,160. 2% growth and 2% inflation would put it at 2,880. Bullish expectations of long-term 2.25% growth and 2.25% inflation would estimate its fair value about at 3,450, or 30% above its current mark. Conclusion Since February 5, 1971 – the first day the S&P 500, Dow Jones, and NASDAQ traded simultaneously – stocks in the S&P and Dow have averaged 7.2%-7.3% annual returns in real terms. The tech-heavy NASDAQ has returned yielded an extra ~220 bps annually due to the higher risks associated with these companies. (Source: measuringworth.com) At 5.05% expected forward real returns forward, this means stocks are overvalued purely going by the returns of the past. Investors currently should expect annualized forward real returns of about 2.2% below historical levels.