This post is an installment in a continuing series supported by The Dynamist's Market Valuation Model. Please click the link to see past installments.
As usual, we start by examining the current state of the interest rate complex, which gives us the market consensus of underlying economic policy. The breakdown of the yield curves of US treasury bonds, muni bonds and corporate bonds is shown below.
If we look at the market's inflation expectations, it is generally assumed that the Federal Reserve will succeed at maintaining inflation right around its target range of 2%-2.25% over a variety of time horizons. Real interest rates (the inflation-adjusted rate on the Treasury Inflation Protected Securities or TIPS) are expexted to remain low for the forseeable future, averaging NEGATIVE -0.5% over the next ten years. This implies that the sluggish economy will force the Fed to maintain nominal interest rates below the rate of inflation for more than five years at least. This would be consistent with my view that we are in a long down cycle as the world economy struggles under its large debt load, resulting in weak demand relative to supply. (The phase known as the Kondriatev Winter to you cycle theory buffs.)
The combination of below equilibrium real interest rates and equilibrium inflation expectations results in nominal treasury yields well below equilibrium. And even though the spreads of municipal and corporate bonds relative to treasuries are currently attractive, their resultant nominal yields are relatively unattractive. While this would normally singal that fixed income in general is overvalued at this time, I believe the bond market is accurately reflecting the likely long term economic scenario, meaning that bond yields are unlikely to rise significantly in the intermediate term at least. Overall, I am overweighting cash and intermediate munis and corporates and underweighting treasuries (and I have sold all of my TIPS).
I'll discuss what this rate structure means for the dollar, gold and commodities in a future post.
As long time readers of these columns are aware, I base my assessment of equity values on the S&P price relative to the long term trend in inflation-adjusted earnings. Using long term returns that fail to take into consideration the unnaturally large surge in inflation during the 1970s will overstate the long term earnings growth assumption. It was the great surge in prices (and thus nominal earnings), followed by the long decline in interest rates that underpinned the massive bull market since the 1980s. I tend to believe that it would be folly to expect a repeat of those extreme conditions.
The long term chart of inflation-adjusted S&P 500 earnings is shown below, along with the calculated trend line.
So while the earnings of the S&P500 were $86.95 in 2011 and are expected to be $97.98 in 2012 (according to S&P analysts, not Wall Street analysts) and $108.76 in 2013, the trend earnings were only $64.88 in 2011 are only $67.73 over the next twelve months. In this view, the trend market PE is about 20, as opposed to 13 or so on projected forward earnings.
The chart below breaks down the components of the projected S&P return, which I calculate to be 7.6%. This return is below what I believe to be the equilibrium return of 8.3%, but is not wildly off.
If you want to earn an 8.3% return, you would have to wait fot the S&P500 to drop to a PE of 16 on trend earnings. That level is currently 1104, about 19% below where it currently trades. That said, given today's interest rates, a 7.6% return sounds pretty good. In fact I calculate the current the equity risk premium (the spread of the expected equity returns over the risk free rate) to be 5.4%, above the proper premium of 4.0% (according to my read of the literature, at least).
Another way to look at PE is to reverse the ratio to earnings to price, or earnings yield. The chart below shows the earnings yield of trend earnings over time. The current yield of 5.2% is more in line with the late stage bull market of the 1960s than the bear market or early bull market valuations of the 1970s or 1980s.
One potential flaw in my model is that my trend earnings could be too low, dragged down by artifically low earnings in the 1970s and 1980s and ignoring the structural changes like globalization that have permanently increased corporate earning power. There may be some validity to this view, but I could easily counter with the theory that recent earnings have been artificially inflated by financial earnings and the effect of the weak dollar on foreign income.
Have corporate profits peaked?
Let's see what the statistics say. If I take the level of corporate profits in the economic statistics and compare them with GDP, we can see that corporate profits are indeed at record levels.
The trend for corporate profits has been on the way up for the past few decades, now exceeding the levels from the mid 1960s. If we break down corporate profits into domestic profits vs. financial and "rest of the world" profits, however, we come up with a different story.
Domestic corporate earning power relative has remained in the same "trading range" since the early 1970s, oscillating between 4% of GDP at lows to around 7.5% at highs. The level is currently 7.3%, signalling that they may be near a cyclical peak. The big change over time has been the increase in financial and rest of the world profits. Financial profits have increased steadily with the long bull market in treasuries, which we can probably safely say has likely run its course. As interest rates flatten out and as Dodd-Frank and Basel III regulations are implemented, it is highly probable that financial profits as a percent of GDP will decline over the next decade.
Rest of world profits have recently caught up with financial profits (they are roughly equal now). Foreign profits could fall with a strengthening of the dollar or any sort of rollback of globalization, either of which are possible or even likely in this environment.
Teed up for disaster?
While not necessarily likely, the outlines of a potential meltdown scenario for earnings is becoming more clear: the quagmire in Europe, leading to banking problems, leading to a crash in Chinese real estate, leading to a rising dollar, leading to a crash in commodities, leading to a bout of deflation, leading terrible earnings, leading to a stock market swoon.
The alternative scenario is that we are headed for a weaker version of the late 1990s, where after a mid-cycle slowdown the US economy steams ahead on the back of a powerful investment cycle as real estate investment recovers and business investment picks up its pace. The US could be able to prosper even while Europe languishes, with US imports keeping Asia afloat. In my last post "Atlas Done: The US Can't Carry the World Economy" I argue why this scenario would be difficult to achieve, but I have been wrong before. In this event, we could see domestic profits continue to head higher and to reach the levels to the late 1960s relative to GDP, rendering my trend earnings too low and making stocks a screaming buy at these levels.
The other perhaps most likely scenario is that the US real estate market, Europe and China can all muddle through for the next year or two. In this case, the market would trade choppily for the next few years as time continues to heal the wounds of the credit bubble. Private sector debt levels would gradually decline until the point that the private sector is able take the growth baton back from the public sector. In this scenario, an investor would want to be modestly underweight equities and overweight fixed income. This is the "Rounded Bottom" scenario that I view as my base case.
I continue to believe that we are riding a cyclical bull within a secular bear market and that investors need to be careful here. The chance of a deflationary crash probably exceeds that of a powerful second leg to the bull market. The most likely scenario is more of the same. The good news is that we are likely nearer to the end of the long bear market than we are to its beginning. In the meantime, caution should rule the day.
I am not your financial advisor and I write these articles purely for my own enjoyment. Please consult your own financial advisor before acting on any recommendations or views made in this article.