It shouldn’t be surprising that the current ‘mood’ just oozes caution. The market is kind of like the bear (I met one face-to-face in Alaska many moons ago while fishing in ‘his‘ creek) - at one moment the bear seems content and not at all interested in us, then all of a sudden we’re mauled (the real bear I met graciously let me walk away).
Who would have guessed back in August of 2013 that the stock market would be where it is? Forget guessing. I know a rather obscure business professor who called it precisely…and kind of by accident. Below is an excerpt from the lecture notes I prepared before the fall term last summer.
A perpetuity is a stream of payments forever. Once again, a formula can be derived from the formula for an annuity. If “A” is the annuity value, “i” is the appropriate discount rate and n is the number of periods then:
PV (annuity) = A x ((1 – 1/(1+i) to the exponent n). AND if n = ∞ it REDUCES to:
PV(p) = A/i
This comes in handy. For example say the S&P500 has a Price/Earnings ratio (we’ll get into this in more detail in future) of 18.59 = Index Price/Index Earnings
If at the same moment, the S&P500 Index price at the time was 1702, and we know the P/E ratio (from Wall Street Journal) is 18.59X. can work out the earnings:
Solving for: P(1702)/E = 18.59 = so E -= $91.55 (earnings of the S&P 500 Index).
If the index earned this forever (no growth) should at least be worth:
$91.55/.05 = $1831. (PV of annuity, and earnings are the annuity).
Does it get any better? You might think I’m being flippant, or worse (self-congratulatory). I managed portfolios for over thirty years, and couldn’t be more humbled. However the very few things I did learn have proven to be very robust. If you scan through many of my past blogs, you’ll find that my rules-of-thumb have been pretty darn accurate – anticipating (rather than ‘predicting’) corrections, falls in commodity prices (gold especially which has neared my target of $1000 despite the condemnation I received in the many comments I received from various readers of my blurbs) and optimism about China. There has been no shortage of pessimism about China’s economy, but ever since I wrote about it the news has been nothing but good even if their stock markets have not (yet) begun to reflect reality.
There are of course far more sophisticated methods of determining value. I’ve always been a big fan of Ford Equity Research. In this chart, when their proprietary Price/Value Ratio = 1.00, stocks are fairly valued. You can see that the market has in a short time gone from undervalued (when I did my own back-of-the-envelope calculation) to what seems to be pretty overvalued at present. Of course, their modelling is far more intricate than my own, but the result is usually the same.
So what’s next? Beware higher interest rates (BAD!!!!) and earnings expectations being revised downward (also BAD!!!). If this is what’s in store for us over the next few months, then indeed the bear is about to maul the likes of us.
What do the soothsayers have to say?
I copied the following from Business Insider (Jan. 7, 2014) under the heading: “Wall Street’s Biggest Bear In 2013 Just Published Her 2014 Outlook, And It’s Wild.” Wells Fargo’s Gina Martin Adams had a 1440 target for the S&P 500 (ouch) all last year (ouch).
“Adams just published her 2014 outlook, and her new year-end S&P 500 target of 1850 — just above Monday’s close of 1837 — is once again the lowest on the Street (although this year, she’s joined at the bottom of the range of forecasts by Deutsche Bank’s David Bianco and Barry Banister at Stifel Nicolaus, who both share her new target).”
What’s funny is she admits that between now and the end of 2014, stocks could go up about 15%, AND could go down 18%. I think its funny because it’s probably accurate but hardly useful. Timing is everything!
Most ‘experts’ seem to be expecting 2014 earnings growth to be in the neighborhood of 8%. This in my estimation is just too boring to take seriously. Based on China’s continuing rebound and its global impact, I’d say 20% earnings growth is in the cards this year, with a substantial rebound in sectors sensitive to China – namely the dogs of 2012 and 2013. (Yes, even gold seems close to its bottom). BUT, the problem with ‘valuation’ is we also need to determine the interest rate environment.
Keeping it simple (like I would for my students), if long T-bonds are say 2%, and a less-than-normal equity risk premium of 4% is acceptable, I’d factor in (since tapering will be the norm globally) a discount rate of 6% (marginally higher than what I used 6 months ago). Index earnings haven’t changed much yet (around $97) so $97/.06 = $1677. That’s about 8% to 9% lower than its present value. This correction is imminent. BUT it’s not a longer term expectation because it assumes no earnings growth. And earnings growth will come.
First, the climbing stock market (not analysts mind you) anticipated that 3rd Quarter earnings would be better than most expected. The market was right! This from Zack’s
For the Q3 earnings season as a whole, total earnings for the 484 S&P 500 companies that have reported results already, as of Thursday morning November 21st, are up +4.9% from the same period last year, with 65.3% beating earnings expectations with a median surprise of +2.53%.
Nevertheless, optimism is already waning. The fourth quarter earnings projections have been coming down (in November) while the most robust of all leading indicators (in my experience anyway) – the U.S. non-manufacturing ISM – unexpectedly fell in December, down 0.9 pts to a 6-month low of 53.0.
Bottom line? Sure the FED can relax some of the easing – after all the employment data is very upbeat. But we will price reduced monetary stimulus in (no, it isn’t priced in just yet) which should shake the 8% to 9% excess out of the market very shortly – so heads up!
The good news, is that estimates of future earnings growth remain far to conservative. Once the consensus adjusts to the end of QE, economic momentum (Europe, China) will drive earnings growth (demand driven, rather than being driven by cost cutting) and before year-end 2014 the S&P500 should see $115 earnings or more. What will this be worth? This question requires some thinking.
Are we near a bubble? Not even close. Have a look at the below chart (courtesy TD Waterhouse Research). Bubbles occur when the earnings yield on the market is lower than bond yields – a ridiculous scenario but a recurring one nonetheless.
The financial crisis was a special case (liquidity crisis, not a stock market bubble) but clearly whenever the earnings yield for the riskiest asset falls below less risky asset yields, we experience the proverbial stampede to exit the market. We’ve quite a long way to go before this cycle is over.
If inflation remains fairly benign, and the earnings yield were to fall to 6% then the ultimate market peak could be (with bumps along the road) north of 2500. Because it’s likely that ‘some’ monetary easiness (now that it is considered good ‘political’ medicine) will continue to prevail – commodity prices will bounce and present some inflationary threat. So I’d begin to get a bit worried once we get closer to the 2000 level. Rest assured that until you see people behaving like this (see video) there’s no bubble.