VOL. 128 | NO. 95 | Wednesday, May 15, 2013
The Worldly Investor
How High Can We Go?
By David Waddell
Total stock market returns combine dividends with a change in earnings and a change in multiples. Right now, the dividend yield on the S&P 500 is 2 percent. The earnings estimate for the S&P 500, for year-end 2014 as projected by Standard and Poor’s, approximates $120, as trailing earnings equal $100 per share.
Therefore, without any change in multiples, the market could return another 22 percent based upon fundamentals. Handicapping this by 50 percent still projects fundamental returns of 12 percent over the next 18 months … assuming multiples stay constant.
Multiples never stay constant. Many factors hold influence over P/E direction, but inflation and interest rates bear the highest correlations. Using the Fed Model as a blunt instrument for asset class comparison, a 5 percent yield on a 10-year Treasury equates to a 20 P/E for the stock market. Since stocks and bonds represent the primary competitors for investor cash, having a mechanism to compare them like the Fed Model makes sense.
Today, the 10-year Treasury yields 1.9 percent meaning the parity multiple for the stock market equals 53. A multiple of 53 seems a bit excessive and without Fed manipulation, interest rates would certainly be higher. Unsubsidized 10-year bond yields might reach 3-4 percent. At 4 percent, the comparable P/E for the market would be 25. Herein lies the point. If interest rates remain low for an extended period, multiples can and should continue to drift higher from today’s 16.5 level. Intrepid money seeking out its highest and best use will not choose low yields in bonds over comparatively low multiples in stocks. As echo crisis threats recede, buyers will increasingly rely on math over emotion.
If the P/E of the stock market today drifted to 20, with no change in the fundamentals at all, the S&P 500 would price at 1970 – 20 percent higher than today. Add to that the fundamental expansion outlined earlier, and the market could mathematically reach 2450 by Jan. 1, 2015 – 50 percent higher than today.
A 50 percent rise in the S&P 500 seems implausible, as it would certainly attract the Fed’s attention. Somewhere along the way, the Fed would recognize the growing threat of asset inflation as a consequence of interest rate suppression. However, the mission is job creation, and the Fed does believe that rising portfolio values, the so-called “wealth effect,” encourages economic risk taking and hiring. The primary risk the Fed runs is that the increase in asset prices fails to translate into an increase in hiring.
So, now we are in a foot race. If the pace of hiring severely lags the pace of multiple expansion, bubbles will form in the asset markets, increasing the size and probability of eventual loss. If the pace of hiring quickens and overtakes the pace of multiple expansion, the Fed can initiate tightening and deflate asset prices in an orderly fashion. Based upon recent global central bank activity, we are nowhere near the finish line. Be pleased, but beware.
David Waddell, who is regularly featured in the Wall Street Journal, USA Today and Forbes, as well as on Fox Business News and CNBC, is president and CEO of Memphis-based Waddell & Associates.