We think that stocks in the US market will be fully valued when the S&P 500 Index hits the 3000 mark by the end of this decade. Here’s why.
A classic value method is to observe and estimate the equity risk premium (ERP). This method compares the earnings yield (earnings divided by price) to the riskless yield (US Treasury). Some use shorter-term Treasury yields; others use longer-term. Some modify for risk to adjustments in the corporate earnings outlook, while others add an expectations component. Over time, the way an estimate of ERP is derived has become complex.
We use a dozen methods in our shop. The key is either to decide on one method or to use many methods and adjust the mix by weighting them. In any case, take the earnings yield and subtract the selected riskless yield and the difference is the ERP.
The key to the ERP is to assume that it is the amount an investor is getting paid to take on the risk of owning stocks instead of choosing to buy a riskless bond or an interest-paying security.
Let’s just use one reference method for this commentary: the 10-year US Treasury note.
We have now seen enough to estimate 2019 earnings of $150–$160 for the S&P 500 Index. This is the range of estimates after analysts have had some time to revise their numbers and to consider the effects of the tax code changes. These estimates are based on static analysis. We think they are low because we expect some positive impact from repatriation, and we estimate that the US GDP growth rate will be close to 3%, rather than the current updated consensus estimates of 2.5%–2.6%. Remember that in the national accounting system after-tax profits are derived from the GDP with adjustments for foreign factors. Earnings of public companies that trade on the stock exchanges are a part of the profit picture in the GDP accounts. The tax code changes boost after-tax profits; hence they boost earnings.
So let’s use the high-end estimate of $160 for 2019. Now add the nominal GDP growth rate of 3% real plus 2% inflation. Also adjust for internal corporate leverage, because earnings grow faster than nominal GDP does. We have not adjusted for repatriation funds used in stock buybacks. That is going to happen, but we do not know to what extent. That adjustment will only raise earnings per share, but we will assume it is zero for the exercise.
So where are we now? About $160 for 2019 and about $170 for 2020.
The next step is to assume what the interest rate will be on riskless alternatives. We will use 3%. That is our best guess for the 10-year US Treasury note yield a year or so from now. Prices in the bond market today suggest that the 3% number is a bit high, but we will use it anyway.
History says that an ERP of about 3 is a fully priced market when using a 10-year riskless yield. We derive that result by looking at a century of data. So using the 3% number for riskless and adding 3% for our ERP, we get to a 6% earnings yield for a fully priced stock market. That equates to a 17 price-to-earnings (P/E) ratio.
Take the 17 P/E and multiply by the $170 estimate for 2020. The result of this exercise takes you to about 3000 on the S&P 500 – or, shall we say, close to it.
Close enough for our purpose. We could get a little extra earnings kick, and we could also get a weaker earnings picture. We could also get a lower US Treasury yield or a higher one. The key is not to try to guess the actual numbers – hitting them with a two-year forecast is nearly impossible.
For investment management purposes, however, the key is to guesstimate whether the market is richly priced (stay away), fairly priced (be careful but remain at least partially invested), or cheaply priced (raise the weight of stocks compared to bonds). We have been in a long period during which stocks have been favored over bonds. ERP helps explain the rise in stock prices.
Now we are approaching a time when the tailwind for stock prices will stop blowing. Rising interest rates, still-rising stock prices, and a refined earnings picture in the wake of the tax code changes make this wind shift clearer.
Our conclusion is to stay invested in the US stock market but to maintain heightened vigilance. We have not reached the end of this bull market, but we are getting close to the time when it will not pay for investors to overweight stocks.
Lastly, it is important to note that the stock market has often overshot. In the tech stock bubble of 1998–1999, the market had a massive overshoot. In the tech sector in 1999–2000, the ERP was actually a negative number. In other words, investors were paying a premium for the privilege of owning stocks. That is madness. It was madness then, and it will be again if this stock market overshoots. But we are not there yet.
We expect the stock market to experience an interim correction this year, but the trend is still toward higher stock prices as long as the ERP is as attractive as it is today.
We remain nearly fully invested. The last several years have been terrific for US stock market investors who could handle the risk required to be in it. The next two years will be okay but a lot harder. Still, the trend appears to be up.
We can send anyone who is interested the performance results for our ETF strategies over the last few years. Just email me for them.
January is off to a good start. It will be a fascinating year. And the politics of a midterm election year will certainly add to the entertainment, as we have already observed.
David R. Kotok
Chairman and Chief Investment Officer
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