The stock market has rebounded from the selloff of 2022. While rising interest rates were the reason behind the drop in prices, people no longer seem to care.
The intrinsic value of a stock is equal to the present value of the cash flow investors will collect from owning that stock. The mathematical formula is shown below.”D” is the dividend, and “k” is the discount rate used to value a future cash flow to an equivalent present value. “k” is a function of US Treasury Rates + a Risk Premium. That risk premium is the extra return one hopes to earn by taking the risk of buying an asset that has the potential of losing value.
Assuming that dividends will grow at a constant rate, we can simplify the first equation in the second equation above. “g” is the growth rate of dividends. Recognizing that company revenue, earnings, and dividends do not grow at a fixed constant rate is essential. There are years when a company may not increase its shareholders’ dividend. There are times when they have to cut dividends. Many, if not most, companies cut dividend payments during the financial crisis. They needed to do this because they suffered financial losses and needed to preserve cash to survive.
That said, the equation helps make a back-of-the-matchbook value estimate. If interest rates (k) rise, the intrinsic value falls. Likewise, if interest rates fall, intrinsic value rise. If a company’s financial performance improves, its dividend growth rate increases. This will increase the value of a company.
Interest rates plummeted in 2019 and 2020 as the Fed flooded the economy. They also ordered people to stay home and stay away from people to stop the spread of the virus. This lockdown caused tremendous uncertainty as people could not make products and earn an income. To elevate this fear they caused, they gave people cash to pay their bills, and they gave companies cancelable loans to help them stay alive.
The downside of this policy was a shortage of products because people could not produce but had plenty of cash to spend while they sat at home: fewer products and more money caused prices to go up. The Fed realized they caused a problem, so they stopped printing money. While all this was happening, the Federal Government paid for money drops by borrowing.
Even before the lockdown and cash giveaway, the Fed Gov ran significant deficits. Then they got a lot bigger.
- In 2018, the budget deficit was $779 billion. This was the most significant budget deficit since 2012. The deficit was driven by a combination of factors, including tax cuts enacted in 2017 and increased spending on defense and healthcare.
- In 2019, the budget deficit increased to $984 billion. This was the largest budget deficit since 2009. The deficit was driven by continued growth in spending and a slowdown in economic growth.
- In 2020, the budget deficit exploded to $3.1 trillion. This was the largest budget deficit in American history. The deficit was driven by the COVID-19 pandemic, which led to a sharp decline in economic activity and a surge in government spending on unemployment benefits, healthcare, and other programs.
- In 2021, the budget deficit narrowed to $2.3 trillion. This was due to several factors, including the economic recovery from the COVID-19 pandemic, higher tax revenues, and lower spending on unemployment benefits.
- In 2022, the budget deficit was $1.3 trillion. This improvement was due to economic recovery, reduced government benefits, and elimination of money drops.
- In 2023, the CBO estimates the budget deficit to be $1.4 trillion. This estimate is laughable as it is already $1,100 billion in the first six months of the year, $400 billion more than the same period in 2022. We look for a deficit of over $2,000 billion due to continued growth in entitlement spending and higher interest expenses.
Since the Federal Reserve is no longer buying the debt, savers have to do so, and they want higher rates to compensate for inflation and income taxation. This caused rates to rise fast, and stock prices took it on the chin in 2022. Interestingly, people think the Fed is getting inflation under control, so they are projecting a fall in rates sometime in the next few months. This is causing investors to buy stocks once again. Since October last year, stock prices have recovered much of their 2022 losses, particularly the tech stocks.
There is still that nasty little issue of who will buy the debt. As a result, we do not think there will be a drop in ten-year US Treasuries yields. We hold this view with a caveat. If there is a banking crisis or some economic dislocation (e.g., another Silicon Valley Bank, Commercial real estate collapse), then the Fed will step in and buy everything in sight just as they did during the lockdown. This and a flight to safety it institutional investors and individual savers would likely force government bond rates down.
So where do stock prices go from here? Interestingly, prices are respecting the uptrend line from the C19 low. Introducing a parallel line suggests the S&P500 could rise a bit more before having a correction and touching the lower trend line before moving higher once again. Prices do not need to rise before correcting, but they could.
Also of interest is that the S&P500 broke above its August high of last year. This puts weight behind the bullish argument. But what about valuation? It turns out that this tells a different story. The SP500 is currently trading at 4,410. The historical market risk premium over the 10-year treasure from 1925 is 5.05%. The dividend on the SP500 for the last 12 months is $69. If we use the equation above and solve for “g,” we see the market is pricing in a 7.25% constant annual dividend growth rate. Returning to 1975, when the US officially went on the gold standard, dividends have grown at 2.8% constant annually.
This suggests investors are pricing in too much growth. That said, how could that manifest? Equities would need to see a 7.25% annual GDP growth rate forever. Return to 1975 again, the constant annual GDP nominal growth rate on a nominal basis was 3.2%. This suggests that the price of the S&P500 is too high unless we (1) have more inflation, (2) productivity growth, and (3) more population growth than the historical average. We can incision a higher inflation rate, but not above average growth rate in the workforce and productivity.
The NASDAQ 100 comprises the 100 largest companies in the NASDAQ. These are large tech companies. Tech companies are “high beta.” That means when the price of the S&P500 goes up, the NASDAQ 100 goes up more. The rally since the C19 low has been spectacular. This index is up almost 44%. One of the big drivers of this rally is the enthusiasm around AI (Artificial Intelligence or Augmented intelligence, depending on your philosophical bend.) The S&P500 is up just 26% over the same period.
The decisive move in certain companies that should capitalize on AI, like NVIDIA, is driving this index higher. Mike wrote about this phenomenon and suggested it has the characteristics of the DotCom/NASDAQ bubble of 1999. Investors are betting that AI will usher in a productivity boom. That is certainly possible, but the stock market seems to be pricing in a productivity revolution with a fair amount of certainty. We believe AI will have a substantial impact on productivity and wealth creation. What is less clear to us is how long it will take. Stocks are suggesting it is already happening. We will let it up to the reader to decide if that is true.
We think the Russell 2000 is telling a bearish story. The Chart above shows the price action of IWM, the ETF that tracks the Russell 2000. (We do not have access to the price data of that index.) Our interpretant of the price action is that the index has been trading in a range for about a year. It has only mildly participated in the equity price rebound since October 2022. This index is up only 16%. This is a massive underperformance as it has a beta of 1.0 which is the beta of the S&p500. There are some reasons for it. The Russell 2000 contains regional bank stocks which are under pressure. The stocks in this index are small capitalization. They have a higher borrowing cost than the companies in the S&P500 or the NASDAQ 100. So they are hurt by rising interest rates.
Here is a fun fact. The Russell 2000 has a market capitalization of $3.9 trillion. Apple has a market cap of $2.9 trillion. This indicates that stocks are in a winner take all mode. Given the difference in capitalization, financial and technology resources, we think the big caps will benefit from AI first. As they roll out procedures and redesign business processes, they will eventually get to the small capitalization stocks.
Our final thought concerns sentiment. Are people exuberant or anxious? The VIX indicates how much S&P500 option traders think the index could move in a month but is displayed annually.
The current reading is 13.54%. This means that options traders expect the S&P500 to trade within a range of up or down 3.9% with a probability of 68%. This is historically low and near levels witnessed before the C19 lockdown.\
As a final word of caution, the Daily Sentiment Index (DSI) is telling us that people are too bullish. The DSI is computed and published by Jake Bernstein. The index ranges from 0 to 100 and indicates the percentage of bullish investors surveyed. ). A reading of 0 says nobody is bullish. With a reading of 100, everyone is bullish. The DSI is pressing the 90 level, and the DSA for the NASDAQ is ppushing93. These are reading that as associated with near-term tops.
Trade cautiously. The Russell 2000 could be toping now. The S&P500 has an upward bias that will turn bearish if the blue uptrend line is broken. The NASDAQ 100 has an upward bias, and we are looking for a break of the green trendline as the first sign buyers have run out of gas.
