Chas Craig
BridgeTower Media Newswires
Recent columns estimated the fair value yield for a 10-year Treasury. Part 1 concerned medium-to-long-term inflation expectations and Part 2 considered the appropriate real yield. The analysis argued for tacking on a 0.5% normalized real yield to a 2.5% normalized inflation rate, implying a fair value yield of 3%, effectively where it is now. Of course, even if this analysis proves correct, which it may not, one can’t expect the 10-year Treasury yield to simply go to 3% and stay there. But just like how the range for the 10-year has been 1% to 3% over the post-Global Financial Crisis period, I expect it is most likely to range between 2% and 4% for the foreseeable future. In short, the bulk of the move higher in rates (The 10-year began the year at ~1.5%) has probably already happened. Assuming this point of view is correct which, again, it might not be, what does it imply about the fair value of the S&P 500?
Let’s take the bond commentary and pair it with an adapted version of the “rule of 20,” a rule of thumb dictating that the sum of the 10-year Treasury yield and the forward 12-month P/E on the S&P should equal 20. The referenced adaptation is that the original version of this valuation heuristic used inflation (actual or expected). Some also use trailing earnings rather than expected earnings. Obviously, like everything else, this valuation rule of thumb (and its variations) is not infallible, but it as a reasonable starting point. This model also has the advantage of explicitly tying lower (higher) interest rates to higher (lower) valuations, a point that is intrinsically true, even though it never happens in a straight line. Given my 3% fair value estimate for the 10-year Treasury, this indicates a fair value forward P/E multiple on the S&P of 17x, which equates to almost exactly a 4,000-index level, essentially where it is now.
However, I should pair this “stocks seem reasonably valued” point of view with a warning label: Bear markets have historically bottomed at undervalued levels. An S&P at 17x forward 12-month EPS estimates (estimates that are probably at greater risk of being cut a bit than increased a bit) seems fair given current interest rates, and a decent place to considering increasing one’s accumulation rate now that stocks have come off the boil. Doing so does not, however, seem like a no-brainer either. The much more important warning though is to avoid market timing.
Why go through all this trouble to say that stocks seem fairly priced here? The answer is that it provides a framework to better understand what just happened and think about the path forward. As indicated, earnings estimates can be cut, but the reality is that earnings expectations have increased throughout 2022, likely a surprise for a casual stock market observer. Year to date, the meaningful, but far from catastrophic, 14% downdraft for the S&P has been entirely driven by a reduction in valuation (i.e., the forward P/E multiple) brought on by an increase in long-term interest rates, not negative earnings revisions. Based on this analysis, the bulk of the valuation reset has likely already occurred.
Therefore, the bear case for stocks from here is much more reliant upon a point of view that forward year(s) earnings estimates will be revised materially lower. Although there are myriad variables, where one stands on this topic mostly comes down to whether they expect the Fed will achieve a soft landing and avoid inducing a recession while bringing inflationary pressures to heel or if a hard landing is more likely.
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Chas Craig is president of Meliora Capital in Tulsa (www.melcapi tal.com).
