Stock market volatility has increased dramatically over the last six months. Many commentators are saying the increased volatility is a negative sign for stock performance through the remainder of the year and perhaps beyond. As usual they might be right, and they might be wrong. Before we give you our view, let’s look at what we believe are the three main drivers of the increased volatility and see how they are trending.
1. Uncertainty about the timing of the Fed rate hike
2. Earnings worries
3. Valuation concerns
The Fed: Don’t fight the Fed, don’t fight the Fed, don’t fight the Fed. As any seasoned investor knows, these are the first three rules of investing. The Fed has incredible power to impose its will on the markets. Back in the days prior to the Tech wreck, commentators were saying that the Fed’s power to rein in the technology stocks was dramatically reduced because most of these companies used very little debt. The Fed raised its Fed Funds rate seven times before Tech stocks crumbled, but crumble they did. Again in 2009, the chorus of naysayers was deafening in its assertion that the subprime crisis was too big for the Fed. Today the S&P 500 is approximately 300% higher than its low in March of 2009. In our judgement, the Fed can do what it wants. So the single most important question facing investors is, “What does the Fed want?”
We believe the Fed has no intentions of causing a big sell off in stocks. Indeed, Quantitative Easing was all about pushing investors out of riskless securities and into riskier assets, including stocks. Why would the Fed have moved heaven and earth over the last six years to avoid a deflationary mindset from setting in with banks and investors, to toss it all away and send stocks into a tailspin? That is an absolute recipe for recession, and they know it.
The Fed wants to keep a lid on inflation and stimulate job growth, yet it also wants to avoid both another 1995-1999 stock market melt-up and a 2000-2002 meltdown. Our Macro Team believes that the lessons of the 1990s are still very much alive in the minds of the Fed. To accomplish their purposes, they are likely to do a lot of talking but very little acting. We believe Fed Chair Janet Yellen said as much in her speech last Friday. The uncertainty about what the Fed will do is not going away, yet we believe the odds of the Fed slamming on the brakes are extremely low. They will increase rates modestly at some point, but we do not forecast a long string of hikes that would freeze the markets or cause a big sell off.
Earnings: Earnings growth for the S&P 500 over the last 12 months has been a paltry 4.3%. During this same time, stock prices have risen nearly 13%. At the beginning of 2014, we said that stocks were about fairly valued, so the returns for the year would likely be about the same as earnings and dividend growth. A 13% price return on earnings growth of about one-third of that is front and center in the minds of every investment firm we know of. The market has given the weak earnings a pass so far because of two unusual events:
1. The dollar has risen by as much as 20% versus the currencies of other developed countries. Since S&P 500 companies generate nearly 50% of their revenues outside the U.S, they have had to absorb currency losses for the last four quarters. These currency translation losses have significantly reduced reported earnings. This trend cannot continue indefinitely.
2. The entire Energy sector took a huge earnings hit in the fourth quarter of 2014 and will again in the first quarter of 2015. Since the Energy sector represents nearly 10% of the S&P 500, it has also produced a drag on corporate earnings. Once oil prices reach a bottom, this too will cease to be a headwind.
The good news here, which gets almost no attention in the media, is that S&P 500 dividends increased by over 13% during the last 12 months. We consider that an important signal that corporate America believes the two headwinds hurting earnings are temporary.
Valuation: If prices rose in 2014 by 13% and earnings grew by only 4.3%, then the price-to-earnings (P/E) multiple expanded. Indeed, the P/E multiple now stands at nearly 18 times earnings, which is the highest level since 2007. Stocks are not cheap from a P/E perspective, which worries a lot of investors. We have modeled P/Es going back to the 1920s and we find there is no such thing as a “normal” P/E ratio.
Our research shows that P/Es are inversely correlated with inflation. In high inflation periods, P/E ratios have almost always been low and high in low inflation eras. Think of it this way: If we divide earnings by price, we produce something called Earnings Yield. Earnings Yield is stated as a percentage. It is essentially a computation that shows how much a company’s earnings produce as a percentage of it price. This percentage can then be compared to bonds, inflation, or other stocks to determine how good of a deal you are getting. This is how an investor like Warren Buffett determines if Heinz or Kraft is a good deal.
As we said before, the S&P 500 is currently selling for about 18 times earnings. To convert this into an Earnings Yield, we divide 18 into 1 to see that the current level is 5.5%. That means if Warren Buffet was interested in buying the whole S&P 500, he would earn a 5.5% total annual return based on the current earnings. 5.5% does not seem like a great return, but there are two important considerations.
1. How does that return compare to my other alternatives?
While 5.5% may not seem like much, it is terrific when compared to a short list of alternatives. A five-year U.S. Treasury bond yields 1.3%, and a ten-year U.S. Treasury bond yields about 1.9%. Thus, not counting any earnings growth that we may receive in the future, stocks would seem to be a good deal with an earnings yield much higher than bond yields.
As we said earlier, our work has shown that Earnings Yields or P/Es are most highly correlated with inflation. Today, the inflation figure that the Fed uses, the Personal Consumption Expenditure Deflator (PCE) stands at 1.1%. We have found that the spread between Earnings Yield and the PCD over the last 50 years has averaged 3.4%. By adding the current level of inflation of 1.1% to the average spread of 3.4%, we find that the model would suggest that the right level of Earnings Yield for today’s inflation level is 4.4%.
So we can get back to how we normally talk about earnings and prices, let’s re-convert the predicted 4.4% Earnings Yield back to a P/E ratio. A 4.4% Earnings Yield would equate to a P/E ratio of 22.7. With stocks currently selling at 18 times earnings, our P/E finder model would say they are cheap.
2. Is that return all we are likely to get?
The current earnings yield of 5.5% does not factor in any future earnings growth. If the long-term growth of earnings approximates nominal GDP growth of 5% or 6%, the effective earnings yield for today’s investor would double once every 12-14 years.
In addition to P/E, we have another way of looking at market valuations. As we have discussed over the years, we have a S&P 500 valuation model. This is a statistical model that calculates the relationship between various factors including dividends, earnings, inflation, and interest rates. According to that model, we are currently selling about 7% under where year-end 2015 data for the variables are now predicted to be.
Bottom Line
Uncertainties about many different factors have caused stocks to become more volatile. We believe we will know a lot more about Fed actions and the outlook for future earnings beginning in August once the impact of big changes in currencies and oil prices are better understood. Furthermore, valuation is not a problem according to both our P/E finder model and statistical S&P 500 model.
The current market’s volatility will ultimately pass. Based upon what we see, the path of least resistance for stocks is still up. However, it will take a few more months before many of investor concerns will subside. The best course for investors is to ignore market volatility and remain committed to building a stream of growing dividend income.
