What to Expect from the US Stock Market

The S&P 500 has not grown in the last 14 months.
A fundamental and interest rate perspective show that the S&P 500 is overvalued.
Strategies that include stock picking, emerging markets or beaten down cyclicals might prove best.

Introduction

The S&P 500 has rallied in the last two months, from the February 11 low of 1829 points to the current 2083 points. This is an increase of 13% but to understand what is going on in the markets a longer term perspective has to be taken. The S&P 500 reached its all-time high in May 2015 with 2130 points but it had already crossed 2100 points in February 2015. This means that the S&P 500 hasn’t grown in the last 14 months. If the S&P 500 does not break the all-time high level in the next 30 days, it will be the longest no growth period since the 2009 financial crisis. The previous longest no growth period was from April 2011 to June 2012.

Figure 1: S&P 500 from 2006 to 2016. Source: Yahoo.

A halt in growth for a longer period of time could mean several things. Before analyzing those implications let’s first take a look at the market’s fundamentals.

Fundamental Perspective

The PE ratio for the S&P 500 is 22.95. This means that the earnings related returns investors can expect from stocks in the long term is 4.35%.

“Put together a portfolio of companies whose aggregate earnings march upwards over the years, and so also will the portfolio’s market value.” Warren Buffett

This return could increase if corporate earnings grow in the future but currently this is not the case. S&P 500 corporate earnings have declined by 15% since their high reached in September 2014. The decline in the corporate earnings could be one of the explanations for the halted growth of the S&P 500.

Figure 2: S&P 500 corporate earnings for the last 10 years. Source: Shiller Yale.

When talking about market fundamentals the best person to go to is Nobel laureate and Yale University professor Robert Shiller. Shiller developed the Cyclically Adjusted Price-Earnings ratio (CAPE) which uses 10 years of Earnings Per Share (EPS) data to calculate the price earnings ratio (PE) for stocks in order to get a more accurate measure of overvalued or undervalued markets. The below figure shows the historical CAPE and long term interest rate.

Figure 3: CAPE Price earnings ratio and long term interest rate. Source: YALE.

The current CAPE ratio is 26.24, thus at similar levels to the 2007 CAPE. The enigma factor is the low interest rate which enables liquidity and inflates assets. From a historical and fundamental perspective, the stock market is overvalued. The fundamental overvaluation increases the general risk of investing in stocks and when combined with the low interest rates the risks are even higher.

The Interest Rate Perspective

The low interest rate makes the current historically low returns from stocks seem acceptable as investors are in search for any kind of yield. The current yield on the 10-year treasury note is 1.75% which implies that investors are expecting a premium of 2.6% for investing in stocks seeing that the indirect return from earnings is 4.25%. Any increase in the relatively risk free yield on the treasury notes would strongly influence the expected return on stocks. The overview of the FOMC (Federal Open Market Committee) participants’ assessments of appropriate monetary policy indicates that more rate hikes are plausible and consequently higher rates on treasuries and also an increase in expected returns from stocks should be expected.

Figure 4: FOMC participants’ assessments of appropriate monetary policy. Source: Federal Reserve.

The target long term interest rate of 3.5% would probably induce a 4.5% treasury yield that, when adding a stock risk premium like the current one of 2.6% would result in an expected return from stocks of 7.1%. The 7.1% expected return would translate in a PE ratio of 14.08 for stocks. With the current earnings of the S&P 500 this would imply a level of 1277.9 points or a 39% decline from current levels. Except for the fundamental overvaluation and low interest rate influence there is another trend that makes stocks risky, the ETF trend.

Technical and Behavioral Perspective

An interesting article was recently published by Morningstar discussing the shift from actively managed funds to passively managed exchange-traded funds. 18 Morningstar 500 funds suffered outflows of at least 40% of assets under management in the trailing 12 months ended February 2016, 61 shed 25% or more, and 168 had outflows of 10% or more. On the other hand, exchange-traded funds have increased their inflows. For an investor this means that the market is becoming more passive, thus thinks less and is more prone to high diversification by buying small amounts of each component of an asset class like ETFs do. This confirms the previous analysis and makes the detachment from fundamentals and the uncorrelation of the market to the earnings decline easier to understand. As most of the investors holding ETFs are not sophisticated and might easily panic in a stronger market decline the above mentioned potential market decline of 39% due to fundamentals might be even greater due to the investors’ weak hands and forced asset sales by ETFs.

Conclusion

By looking at the corporate earnings investors should expect returns of about 4.35%. The potential negative influence of increased interest rates on corporate profits has not been taken into account in the above return. Any increase in the base interest rate would increase the corporate interest expense and consequently lower corporate earnings. On the other hand, a potential market decrease of 39% makes the risk/reward very unattractive for investors looking for stable long term returns from the stock market.

Seeing that the market has not grown in the last 14 months there can’t be talk about a boom or bubble that would justify the potential downside in the risk reward analysis. The best thing to do could be “Sell in May and go away” or go for the more defensive stocks that have stable dividends and can easily weather higher interest rates, market and economic downturns. The ETF strategies and the trend of investing in them creates possibilities for stock pickers. And last but not least, several markets have been strongly beaten down in the last period and might conceal some long term value. Examples of that are commodities markets, some emerging markets, or for the more risk loving investors a good strategy in this markets could be a short one, but more about that in the next newsletters.