Checking the math
One of the most fundamental operations thatstudents learn at business school is how toestimate the value of an asset based on the cashflow it generates. In this calculation, anappropriate current price is derived by“discounting” income streams at a given rate,often the prevailing bond yield of appropriatematurity or the return that the individual requiresto commit capital to the investment. All elseequal, if the asset can be acquired for less thanthat figure, the investor should go ahead; if not,he or shemay want tolookelsewhere.
This method can be used to gauge fair price for income producing real estate, privately held businesses, listed stocks, and justabout anything generating (or expected togenerate) ongoing earnings. We can also use thetechnique to get a sense of where an entireequity index is trading relative both to itsunderlying fundamentals and how investors havevalued those characteristics in the past.
In the accompanying chart, we’ve compared theactual level of the S&P 500 since the beginning ofthe 1970s with the value that would have beenimplied by capitalizing its trailing annual earningsat the prevailing 10-year US Treasury Bond rate, a maturity that corresponds with the long termcommitment implied by equity investment (we’veused log scale in this illustration to keep the linesfrom running off the page). As you can see, thetwo figures tracked each other fairly closely formost of the period examined, but began to separate about a decade ago, withindexperformancefalling behindwhat corporateprofit and interestrates would havepredicted. In fact,capitalizing theearningsgenerated by the S&P 500 over the past twelvemonths by the current 10-year T-bond ratesuggests that the index should be sitting at about4600 points, or 70% higher than where itpresently stands; if we run the calculation usingconsensus earnings expectations for calendar2018, the figure comes out to more than 5600.
So what could be causing this discrepancy? It’simpossible to say with any certainty, but it is mostlikely one of the following factors, or somecombination thereof. First, it could be that theintersection of earnings and interest rates thathas described markets for generations is nolonger valid and the contemporary investor isappraising stocks based on entirely differentcriteria. Though this explanation is possible, itseems unlikely that such a time-tested andintuitive approach to equity valuation would havebeen abandoned, no matter how different themodern investing environment may appear.Second, maybe the relationship does still hold,but market participants are skeptical of thedurability of reported earnings and are insteadsubstituting their own, greatly reduced estimatesinto valuation models. If this were so, the currentlevel of income generated by the S&P 500 wouldneed to be about 40% lower for the index’scapitalized and actual levels to match, a haircutnot historically seen in the course of a normalbusiness cycle – in fact, calendar year earnings forthe S&P didn’t even fall that much during theeconomic plunge of 2008/09.
A third possible explanation for the divergence isnot that investors are circumspect of earnings,but that they regard our very low-interest rateenvironment as unsustainable, even though it’snow been with us for nearly a decade. In thiscase, the 10-year T-bond yield would have toclimb from its current 2.9% to about 4.7% toclose the valuation gap. Though 4.7% might notseem like an extreme level for a 10-year interestrate, especially to those with memories of the1980s and 90s, such a plateau would represent asignificant relative jump from where we are now.If this occurred, though, it would presumably bedriven by unexpectedly strong economic growthand nascent inflation pressure, which wouldundoubtedly be accompanied by a similar andoffsetting rise in company earnings.
While none of this tells us where stocks will go inthe near term, and certainly doesn’t precludethem from suffering an unexpected drop at anytime, it does leave us relatively content that thefundamental structure of the broad market issound. This comfort allows us to devote moretime and energy to doing what we do best:seeking out individual companies that are doingthings better, faster, and more efficiently than thecompetition and taking positions when theirshares can be had at attractive relative valuations.
Of course, as we write this there’s an elephantstampeding through the room in the form of theUS government’s escalating belligerence towardinternational trade. In last quarter’s commentary,we were sanguine about the darkening skies overglobal commerce, writing that “the initial hardlinestance taken by the US government may turn outto be a bargaining ploy” aimed ultimately atimproving China’s “treatment of intellectualproperty and its habit of requiring transfers ofproprietary technology from firms wishing to dobusiness there”. Now, however, intimidation ishardening to action, with the US activatingpunitive duties on $34 billion worth of importsfrom China and rescinding the exemption to steeland other tariffs previously granted to Canadaand similar allies.
Not unexpectedly, China and several othernations have responded in kind, directing theircounterpunches at US industries for whichoverseas sales are an important source ofrevenue. Notably, though perhaps notcoincidentally, the effect of these measures willbe felt most predominately in Trump country:bourbon makers in Kentucky aren’t happy, amotorcycle manufacturer operating out ofWisconsin and Pennsylvania is reorganizing tododge costs, and soybean farmers in the Midwestare bracing for tough going as the most importantmarket for the country’s largest agricultural exportcloses its doors to American business.
This feature is particularly important asNovember’s mid-term elections approach andRepublicans perhaps begin to contemplate theodds of losing their majority position in theHouse of Representatives. James Carville, chiefstrategist for Bill Clinton during his unexpected1992 win over George HW Bush, famously set thecorrect campaign tone for his staff with his often-repeated refrain, “It’s the economy, stupid.” Inother words, voters would care more about theirpocket books when they went to the polls thatyear than they would about President Bush’srecent triumph in the first Gulf War or his longand distinguished history of service to thecountry.
At present, markets seem to be taking the viewthat similar pragmatism will win the day headinginto the fall and that trade restrictions will eitherbe walked back through negotiation, or at leastlimited to what’s been put in place thus far. TheTSX, for example, quietly reached a new all-timehigh in Q2 and posted its best quarter since 2013,while the S&P resumed its upward path followinga stretch of softness to start the year. Though therising trend continued into the early days of July,we’ll watch developments closely in the comingweeks and adjust portfolios accordingly shouldWhite House direction defy common wisdom andtake a further turn for the worse.
Have a great summer!