The big debate amongst investors concerns valuation. Most of the investors who appear in the financial news media say equities are reasonably priced. Some argue they are cheap. If not all, most argue they are the only game in town, so if you want to get a return, you have to own stocks.
We have argues that the stock market in aggregate is expensive, but there are pockets of reasonably priced stocks. The problem is they are challenge is to identify those investments. In this note, we would like to walk you through our approach to valuation. There are two components to expected returns. There are a risk-free component and additional return one should earn by putting capital at risk.
Practitioners often use T-Bill yields as a proxy for the risk-free rate of return. Hold a T-Bill to maturity, and you will get your money back with interest. Most people believe there is virtually no chance of the US Government defaults on its debt obligations. One always has the choice of buying T-Bills. To entice the investor to take some risk, companies have to promise a higher rate of return. We will look at these components separately.
What is a fair rate of return on T-Bills? It is a yield that will maintain investors’ purchasing power at a minimum to our way of thinking. This can be computed with the following equation.
Fair T-Bill Return = Inflation / (1-Tax Rate)
By comparing the yield on 10-yar treasuries and 10-year inflation-indexed treasuries, one can estimate what the market believes the average inflation rates will be over the next 10 years. This indicator is suggesting that market participants expect an inflation rate of 2.2%.
The next factor in estimating is the tax rate for the typical investor. There is no such thing as a typical investor, as even people with modest incomes can save and invest. The table below shows the marginal federal income tax rate by income. States are not allowed to tax interest income of US Treasury securities.
Fair T-Bill Return = 2.2% / (1-0.32)= 3.24%
Suppose we assume an inflation rate of 2.2% and a marginal tax rate of 32%, then T-Bills must pay 3.24%. What are 1-year T-Bills paying? Just 0.06%. Market intervention by the Fed has forced rates down so that people will not invest in them. Essentially, people are being forced to take financial-risk whether they want to or not. Risk losing to a bear market or lose it to inflation. In the final analysis, US-Treasuries are way over-priced.
So what about the risk premium? The chart above shows the actual risk premium delivered for various periods. Notice on a running 10-year basis (green line) equities had returned as high as 20% a year or as low as -5% a year over 10-year time horizons. The black line shows that stocks, if held long enough, 60 years, in this case, one can expect a 6.5% return premium.
So what does this mean for stock prices? A fair price of the S&P500 would incorporate a fair risk-free rate and a fair market risk premium. Such a model would suggest stocks should be priced to deliver a return of 9.75%. (3.25+ 6.5) for the foreseeable future. Over the past 91 years, large-cap stocks have delivered a return of about 10% a year, and small-cap stocks delivered about 12%.
But, interest rates are suppressed by the Fed. This phenomenon has driven people into the equity markets, pushing up the price of stocks. It has also encouraged companies to issue debt and buy back stock. So now, one should only expect equities to deliver 6.56% (0.06+6.50) over the next few years if we assume investors demand a risk premium similar to what they required for the past 60 years.
Stocks deliver returns in two ways. They pay a dividend and (hopefully) a capital gain. Capital gains come primarily from growth in the underlying business. Changes in interest rates and return premiums cause capital gains and losses, but we will put that aside for the moment.
Equities tend to grow earnings and revenues over time. A simple model for valuing stocks is the perpetual growth annuity model described by the following equation.
Price = Next Years Dividend/(Expected Returns – Expected Dividend Growth Rate)
We can observe price and dividends, and we just estimated the expected return on stocks based on the historical risk premiums and the current T-Bill rate. We can estimate the dividend growth rate if we assume retained earnings generate the same ROE as the existing capital stock.
g = (EPS-DIV/Share)/EPS x ROE
The Earnings per share on the S&P 500 is $98.29.
The Dividend per share on the S&P 500 is $58.28.
The ROE is the EPS/Price per share. The price of the S&P500 equals $3,914. Now we can complete our calculations.
ROE = 98.29/3,194 = 3.1%
g=[(98.29-58.28)/98.29]x 3.1% = 1.3%
Value of S&P500 = 58.28(1+1.3%)/(6.56%-1.3%) = $1,122
This is a country mile away from the current market price of 3,914. This means that investors are expecting a faster growth rate than 1.3%. What growth rate are they expecting.
3,914=58.28(1+g)/(6.56%-g)
Solve for g, and we get = 5.0%
So if you think corporate earnings and dividends will grow at 5%/year forever and you think T-Bill rates will remain at 0.06% forever, then you could conclude that the S&P500 is fairly valued. But what if you think interest rates will eventually work their way back to fair value (i.e., circa 3.24%). Then the fair value of the S&P 500 is $1,288.
Price = Next Years Dividend/(Expected Returns – Expected Dividend Growth Rate)
$58.28(1.05)/(9.75%-5.0%)=$1,288
Since we think it is just a matter of time before interest rates rise as investors demand a fair rate of return on T-Bills, we think there is the possibility that equity prices could crater in a big way. To justify the current price of the S&P500, the growth rate would have to rise to 8.14%. We do not see that higher interest rates will increase corporate borrowing costs, which will suppress earnings.
Most investors do not think interest rates will rise for years to come. The Fed says they will continue to suppress interest rates for the time being. But long-term interest rates are starting to rise. This is the first clue that the market may push the Fed to stop the easy money.
By the way, we think this is the reason bitcoin is running higher. People are looking to put their money where it will not lose purchasing power due to inflation. We may be about to enter interesting times. Anything that may shake investor confidence may bring on a correction and perhaps a severe one. There is another way out, and that is 10 to 15 years on no returns allowing company valuation to catch up with their market price. This is the story of Japan as their equity market still has not returned to 1999 levels. They have had 2 dead decades.
In the final analysis, stocks, in general, are priced to perfection. To make a buck going forward, one should focus on value stocks that investors shun due to their lack of exciting growth rates. From here on out, success will be about stock selection. Buying and holding index funds and ETFs is likely to be a more volatile and not lucrative ride.
From an investor behavior perspective, there are many indicators that investors are throwing caution to the wind. This is the kind of thing one sees at market tops. We have shared some of these indicators on these pages, and Twitter @MGuthner, @the_OptionsEdge, @Michael_Khouw and will continue to do so to keep you abreast of potential dislocations and important market impacting information.
Photo by Emily Morter on Unsplash
