This week I want to jump into the weeds with you and outline our current thinking on the stock market. On May 13th, I wrote:
“The S&P 500 is now trading at 17.3x 2022 estimated eps vs its historical average forward P/E ratio of 16.7x. Analysts have increased their full year earnings estimate to 228. We would estimate a range of 200-230 eps for the S&P 500 this year, so fair value is in the range of 3,400-3,900. The low-end accounting for a recession and the high-end pricing in decent year over year earnings growth…
So basically, we now have a stock market that is at the top end of fair value combined with investor panic. Those two conditions historically have been buy signals for long-term investors. We have no idea how much more selling is left in equity markets in the short-term, but we are getting more uncomfortable with our underweight equity positioning. We are going to start slowly adding stock exposure to the portfolios. If the market continues to decline—assuming no significant change to the economic outlook—we will get more bullish. We might be too early with this change of direction, but we aren’t trying to time the market in the short-term. Our process is about investing in assets that have the right balance of risk and reward over the long-term.”
After sending that note, we were only able to add a small amount of equity to the portfolios before the market bounced back above our buy levels.
However, with the recent decline, the markets are back to the top end of fair value at 3,900. So, I would like to explain that last line and give you a lot more information about how we determine the right balance of risk and reward over the long-term.
Historical Context for Stock Valuation
Over the last 20 years, the S&P 500 has produced an average annual return of 8.5%. Those are great returns and had a lot to do with the starting point in the year 2002.
We had just suffered a multi-year stock market crash and recession with many major companies going bankrupt and everyone still reeling from 9/11. The market at that time was trading at a forward P/E of only 11.7x or an earnings yield of 8.5%. With the 10 Year Treasury Bond yielding 4.0%, Equity Risk Premium was 4.5%.
Equity Risk Premium is the additional return provided by stocks above the US Treasury Interest Rate and accounts for the added risk inherent in owning stocks vs. bonds. Traditionally the ERP has been between 3-4%, the higher rate appearing during times of stress/recession and the lower rate occurring during expansionary periods. At 4.5% the ERP was very attractive and nearly 30% above average.
Fast forward a decade to 2012 and the S&P 500 had returned only 5% annually and was trading at 11.9x forward earnings. This was in large part due to the massive crash and global financial crisis that happened in 2008 & 2009. The earnings yield was 8.4% and with the 10 Year Treasury Rate at only 1.8%, ERP was enormous at 6.6%.
From 2012 to the end of 2021, the S&P 500 produced an average annual return of nearly 13.5%. These very elevated returns were due to steady earnings growth of 7% and a shift in valuation from 11.9x to almost 22x forward earnings. At the beginning of 2022, the earnings yield for the market was only 4.5% and with the 10 Year Treasury Rate at 1.75%, the ERP was a measly 2.75%.
Here is the takeaway—Long-term stock market returns are a function of Earnings Growth Rates, Interest Rates and Equity Risk Premium.
Current Stock Fundamentals
With the S&P 500 now trading around 3,900 the current earnings yield is 5.8% assuming analysts are right about their 2022 earnings estimate of 228. Remember we are forecasting EPS of between 200-230 depending on recession. In our recession scenario the current earnings yield is around 5.2%.
We assume that in the non-recessionary scenario the 10 Year Treasury Rate would remain around 3% but in the recessionary scenario rates would fall to at least 2%. These would produce current ERPs of 2.8-3.2%. We would prefer to see forward P/E ratios on the S&P 500 of 16.7x or an earnings yield of 6% for fair value. That gives us our range of 3400-3900 target.
When we invest, we focus on the relative long-term returns of various asset classes around the world. We calculate the probable 10 Year Expected Returns and compare those to fair value for the asset class and to other asset classes.
At 3,900, the S&P 500 has a mean expected 10 Year Return of 5.5% assuming 7% earnings growth and a 6% terminal earnings yield.
US Large Cap Stocks
At 3,400, the same index would produce expected returns of around 7.25% for the next decade. We think that a 7% annualized return over the coming decade is a solid return for US Large Cap stocks which would represent a 4-5% ERP.
Comparing US Large Cap stocks vs other markets around the world shows a preference for international and emerging market equities, presently.
Non-US Large Cap Stocks
Emerging Market Stocks
These three categories are high level, and we obviously have investments in various Industry Sectors and Countries that we think are better opportunities than the aggregate benchmark indices.
Conclusion
- US stocks are becoming more attractive as prices fall.
- We will be buyers of stocks as their long-term expected returns improve from current levels.
- Even at current prices, the likelihood of zero or negative long-term returns in US Large Cap stocks is very low at 5% probability.
