U.S. stocks may soar higher – only to crash-land

March 12, 2013

By Martin Hutchinson

The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

The S&P 500 Index of U.S. stocks is nearing a new record close to eclipse the peak of 1,565.15 set in October 2007. Simple interest-rate based valuations, such as the so-called Fed model, suggest the benchmark could more than double again – but on long-term assumptions, it would then crash-land.

The Fed model equates the earnings yield on stocks with the prevailing 10-year Treasury bond yield. This yardstick proved a reasonable predictor for shares between 1982 and 2007, with stock markets rising as interest rates fell. The relationship has broken down since then.

The model named for the Federal Reserve is flawed, accounting neither for the inflation protection built into stocks nor, on the downside, for the extra risk of stock over U.S. government bonds. Nevertheless, ultra-low interest rates tend to push stock prices higher. Were the S&P 500 to align with the Fed model so the earnings yield equaled today’s 2 percent return on 10-year Treasuries, it would top 4,000. Matching the previous high in 2000 for the index adjusted for the nominal size of the U.S. economy would bring a new peak just shy of 2,500.

Even that would represent a significant bubble. In fact, the current level of the S&P 500 is a stretch. Based on current as-reported earnings and a 1950 to 2012 average price-to-earnings ratio just under 19 times, according to data compiled by economist Robert Shiller, a figure of around 1,600 is on the money. Today’s U.S. corporate earnings, however, are flattered by low interest rates. They totaled 12.5 percent of national income in the most recent government statistics. Since 1950, the average is 9.5 percent. Overlay that adjustment, and the right level for the S&P 500 would be nearer 1,220.

Alternatively, apply the Fed model using a long-term average Treasury yield. Take current S&P 500 earnings and apply a 50-year average yield of 6.6 percent, and the result would put the index at about 1,290. Assume earnings will decline as a proportion of national income, as above, and that drops to about 980. Dividends reveal a similar picture. The average dividend yield on the index between 1950 and 2012 was 3.3 percent. The current yield is 2 percent. Assume a reversion to the long-term mean, and the S&P would drop by nearly 40 percent.

Or look back to February 1995 when then Fed Chairman Alan Greenspan embarked on policies that expanded the money supply much faster than the pace of economic growth. The S&P 500 stood at about 487. Apply the growth in nominal GDP since, and it implies an index level of 1,060. Once interest rates and other factors normalize, the index could slump by a third from current levels – and far more should investors first inflate it further.

Comments

Thanks for this. A good (circular) assessment…

Interested to hear and see a similar your assessment on the Fed exit options i.e., to unwind the balance sheet of the Fed and pull in Money Supply.

Would the argument be that at some turning point – 6.7% UE, LTI of 2.5% and rising “real wealth” asset prices – bonds and MBS will normalize in price (i.e., yields will rise)? And that the normalization of yields would not be seen as detrimental to US economic B/S because of the impact lower relative currency position (vs. 2008) will have on corporate profits?

This would seem to make sense of the Feds position i.e., that Bernanke then can unwind or sell back MBS or sit on the expiring bonds acquired – provided the world does not have a “shock” event (i.e., major war, loss of faith in US credit, or trade / currency wars or regional economic collapse or basic resource shortage) emerge. True?

Or is it that we are missing something here… namely that the NAM and EUR flat lines under austerity (i.e., corporate cost cutting can go no further) – resulting in stubbornly high unemployment, capital / human flight to high risk / emerging assets and/or capital being returned to its owners? Thus perhaps stimulating a re-emergence of inflation – led by the emerging economies who perhaps may stimulate a wealth effect for their households through political means), which in turns lifts yields/the price of risk in the developed economies thus stifling credit and growth further = stagflation?

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