Fed Stock Valuation Model
Asia Pacific Market Strategy - Signposts For The Bull Market
- Aggressive monetary expansion will cause more speculative bubbles to emerge periodically in specific stocks. It will also likely drive the US dollar yet lower, in our view.
- But high stock valuations are likely to be tolerated for a lot longer while rates and yields remain ultra-low.
Concerns over periodic outbreaks of mania
- We have seen the longest bull market in history (from March 2009 to February 2020), followed by the shortest bear market in history (20 February 2020 to 23 March 2020), amidst the worst pandemic in a century. So, it was inevitable that this latest bull market would provoke calls of “bubble”, including from some of the world’s best known asset managers.
- That there are little bubbles forming is undeniable. Witness the stories of hordes of day traders forming social media communities to send obscure stocks and other assets through the proverbial roof, sometimes on perceived (and on one occasion, mistaken) signals from Elon Musk.
Valuations generally high by historical standards
- And that valuations are high by historical standards is also undeniable. Yes, the S&P 500 forward 12-month forward P/E ratio is currently at 21.8. The 5-year average is 17.6 and the 10-year average is 15.8. And the Shiller Cyclically Adjusted Price to Earnings Ratio (CAPE Ratio) is now at a bit over 33. This is the second highest in the history of the S&P 500, exceeded only in the late 1990s, in the lead up to the Nasdaq Crash.
The role of interest rates and government bond yields
- But none of the above takes into account the shifting discount factor in valuation. The 10-year US Treasury yield in January 2000 peaked at 6.8%. It is currently 1.1%. The rise in market valuations may simply be reflecting the inverse relationship between the net present value of a stream of expected future cash flows and the discount rate applied to those calculations. The inverse correlation between the S&P 500’s TTM P/E ratio and the 10-year US Treasury bond yield is clear.
Valuations, overlaid with interest rates, look much more benign
- The so-called “Fed Stock Valuation Model” – which compares the market’s forward earnings yield against the 10-year US Treasury yield – showed a healthy spread of around 350 basis points between the two by the end of last year (4.51% for the S&P 500 forward earnings yield minus 0.95% for the 10-year US Treasury yield).
- Using dividend yields as an alternative, we have a 59 basis points spread between US stock dividend yields and the 10-year US Treasury yield, a level which has not been seen in over half a century of data, except for a brief spike during the depth of the Global Financial Crisis, which was likely an anomaly linked to sharp falls in stock prices.
- On the same theme, although the Shiller Cyclically-Adjusted Price to Earnings Ratio (CAPE Ratio) for the S&P 500 is historically high at around 33x, the current valuation looks much more reasonable when adjusted for interest rates. The so-called “Excess CAPE Yield” – which inverts the CAPE ratio to derive an earnings yield, which is then adjusted by subtracting the 10-year real earnings yield – is currently at 3.7%, a level which historically favours positive to strong subsequent 10-year annualised returns.
The risks of financial instability are rising but they may accelerate rather than end the bull market
- There has been some concern over the rising level of margin debt, seen as yet another manifestation of a growing bubble. But there is nothing particularly unusual about this. The rising tide of money supply over the past decade has driven up stock prices, and with the rising value of the stock market has come higher absolute levels of margin debt. So, the rise in the level of margin debt is simply a function of the size of the stock market’s capitalisation. Indeed, the percentage of US margin debt to the market capitalisation of the NYSE has gone down from 1.8% at the end of 2010 to 1.5% by the end of 2020.
- Of course, none of this is to deny that a higher absolute level of margin debt caused by inflating asset values can eventually be a source of financial instability. But it is important to also have some perspective on this in terms of the larger monetary phenomenon.
Bull markets usually end in fire
- The saying goes that bull markets are born in ice, and bear markets are born in fire. Almost every US bear market over the past 70 years (with the exception of the brief so-called “Kennedy Slide” of 1962) has been preceded by rising inflation and a rising Fed Funds Rate.
Despite the rise of speculative mania, there is still no fire
- It is true that US inflationary expectations as reflected in the 10-year Breakeven Inflation Rate have been rising, and quite sharply too, from March of last year.
- The 10-year Breakeven Inflation Rate is derived from the 10-Year US Treasury yield minus the 10-year Treasury Inflation Protected Securities or TIPS yield. If inflation is unchanged over the next 10 years, you should get pretty much the same total returns from holding a 10-year US Treasury as you would from holding a 10-year TIPS. But if the market expects inflation to rise, it should logically be selling US treasuries and driving up the nominal 10-year yield, while buying TIPS, driving down the equivalent maturity TIPS yield. In the process, it drives up the spread between the 10-year US Treasury yield minus the 10-year TIPS yield, resulting in that spread being used as an approximation of the market’s inflation expectations.
- But note that the 10-year US Breakeven Inflation Rate has diverged sharply from the 10-year US Treasury yield. They both started at about the same level this time last year, at around 1.6%. But while the 10-year Breakeven Inflation Rate has run way above pre-pandemic levels, the 10-year US Treasury yield is still very much below the levels of a year ago.
- This may be what the bond market is hinting to us about how it thinks this movie will end...
- Right now, central bankers are more concerned with breaking the ice than fighting fires...
- Technically, there is no limit to the extent to which the Federal Reserve can expand its balance sheet to finance the government’s deficits...
Read the PDF report attached below for complete analysis with data charts.
LIM Say Boon
CGS-CIMB Research
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https://www.cgs-cimb.com
2021-02-08
