Robert J. Swartout, The Daily Record Newswire
Back in May 2013, I authored an article titled “Irrational Exuberance” playing off of that famous phrase from former Fed Chairman Greenspan. Chairman Greenspan had introduced a valuation methodology in his semi-annual testimony before Congress that attempted to provide a relative valuation between stocks and bonds.
The “earnings yield” is defined as the next 12 months earnings estimate for the S&P 500 index divided by the current level of the S&P 500 index. The current 10-year Treasury note yield is used as a proxy for the bond market. This valuation, routinely referred to as the “Fed Model,” subtracts the current 10-year US Treasury yield from the earnings yield and produces the Equity Risk Premium.
In theory, the equity asset class should be more attractive if the ERP is positive and less attractive if the ERP is negative. In the late 1990s, the ERP was at a negative 3 percent, suggesting that stocks were not as attractive as bonds. Since the peak in early 2000, the 10-year Treasury yield has declined from more than 6 percent to around 3 percent today, resulting in a significant bull market in Treasury prices.
Remember that bond prices move in the opposite direction than rates. So we are coming off of a decade-long bull market in bonds and, with the exception of last year, a relatively flat market in equities.
We began last year with forward earnings estimates of $103.81 divided by the S&P 500 at 1,429.19 delivering an earnings yield of 7.28 percent. The 10-year U.S. Treasury was yielding 1.76 percent. The ERP, calculated by 7.28 percent-1.76 percent started the year at 5.52 percent. In 2013 the S&P 500 was up 32.4 percent and the Barclays Govt. Credit Bond Index was down 2.34 percent. A performance gap of 34.74 percent!
The Senate has just approved a new Fed chair, Janet Yellen, to take the reins from Chairman Ben Bernanke. Although we have new leadership at the Fed, I expect that the Fed model still applies and it might shed some light on what we can expect for 2014. The earnings yield for the S&P 500 is 6.44 percent and the 10-year Treasury yield is 2.979 percent. The Equity Risk Premium is a positive 3.461 percent, which suggests another strong year for the S&P 500 relative to the broad bond market.
In addition, the Fed has begun to taper their quantitative easing strategy, which suggests that they are seeing an economy that is getting stronger and may not need as much Federal Reserve support. A stronger economy generally means better earnings growth and the Equity Risk Premium may grow as a result.
The primary risk to this thesis is if inflation begins to appear and interest rates rise rapidly in reaction to higher inflation expectations. The core consumer price index, CPI (ex. food and energy), is currently 1.72 percent for the past year. Existing home sales and employment, two of the largest components of inflation, still have not shown very much in the way of an economic recovery and suggest that inflation over the near term will not be an issue.
The S&P 500 earnings are estimated to be 14 percent higher in 2014 than in 2013 and the current Price to Earnings ratio based on the next 12 months earnings is only 15.5. Recall that the S&P 500 reached a Price to Earnings ratio of 31 during the speculative tech bubble of 2000.
So after a very strong equity market last year, it would appear that stocks continue to be cheaper than bonds, the S&P 500 is fairly valued with a P/E multiple of 15.5 and earnings growth of 14 percent and inflation is well in check below the Fed’s target of 2 percent. I am looking forward to another strong year in the stock market.
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Robert J. Swartout is a vice president at Karpus Investment Management, a local independent, registered investment advisor managing assets for individuals, corporations, nonprofits and trustees. Offices are located at 183 Sully’s Trail, Pittsford, N.Y. 14534; (585) 586-4680.
