The Econtrarian: November 2017

Tuesday, November 28, 2017

The S&P 500 Is Not Expensive According to the Kasriel Valuation Model

November 29, 2017

The S&P 500 Is Not Expensive According to the Kasriel Valuation Model

In each of the first three quarters of 2017, there have been double-digit year-over-year percentage increases in the quarterly average level of the S&P 500 stock-price index – 19.3% in Q1, 15.5% in Q2 and 14.2% in Q3. Although there were year-over-year contractions in the S&P 500 index of 5.6% in Q1:2016 and 1.3% in Q2:2016, there has not been a year-over-year contraction of 10% or more since Q3:2009. With the S&P 500 stock-price index hitting record highs in recent weeks and no contraction of 10% or more in it in eight years, one could reasonably wonder if large cap stocks have gotten expensive. In terms of the Kasriel stock market valuation model, the S&P 500 stock price index was not expensive in an historical context as of this past third quarter.

The essence of the Kasriel stock market valuation model is a calculated theoretical market capitalization of a group of stocks compared with the actual market capitalization. If the actual market cap is larger than the theoretical market cap, then the stock market group is overvalued. If the actual market cap is less than the theoretical market cap, then the stock market group is undervalued.

The theoretical market cap is calculated by discounting corporate earnings by a corporate bond yield. Thus, the theoretical market cap varies positively with the level of earnings and negatively with the level of bond yields. For corporate earnings, I have used quarterly observations of aggregate S&P 500 reported earnings, starting in 1964:Q1. (I would have preferred to use operating earnings, earnings adjusted for one-time special events. But in my database, operating earnings data do not begin until 1988:Q1.) I smooth the earnings series with some highfalutin econometric technique called the Hodrick-Prescott filter. The Hodrick-Prescott filter is supposed to remove the cyclical component of a series. Think of it as less arbitrary technique than a moving average, such as Shiller’s use of a 10-year moving average. Why 10 years? Why not 9 or 11 years? So, my theoretical S&P 500 market cap is Hodrick-Prescott filtered quarterly aggregate S&P earnings discounted by the quarterly average level of the corporate BAA bond yield. After calculating the theoretical market cap of the S&P 500 stocks, I calculate the percentage that the actual S&P market cap is over or under the theoretical S&P 500 market cap.

The results of these calculations are plotted in Chart 1. According to the Kasriel model, S&P 500 stocks in the aggregate were overvalued by 4.4% in 2017:Q3. Compared to the average overvaluation of 36.1% over the entire sample period, a 4.4% overvaluation is small potatoes. The level of the corporate bond yield used to discount smoothed annualized earnings of $899.1 billion in this past third quarter was 4.35%. Given the same level of annualized earnings, a 100 basis point increase in the corporate bond yield would put third-quarter S&P 500 stocks 28.4% overvalued, still short of the sample average of 36.1% overvaluation.

Chart 1

Testing the lead/lag relationship between the Kasriel valuation model and the year-over-year percent change in the S&P 500 stock price index shows that the highest negative correlation (-.20) between the two series is obtained when the over/under valuation measure is lagged by five quarters. So, the current quarter’s over/under valuation estimate has its greatest effect on the year-over-change in the S&P 500 stock price index five quarters in the future. Let’s plot the year-over-year percent change in the quarterly average of the S&P 500 stock price index against the Kasriel model of over/under valuation estimates lagged five quarters to see how the Kasriel model comports with the behavior of stock prices. These data are plotted in Chart 2.

Given the low absolute value of the correlation coefficient between the two series, 0.20, you would be correct in assuming that the Kasriel over/under valuation model does not do a stellar job in predicting the year-over-year percent changes in the S&P 500 stock price index. (Gosh, and I thought it would be easy to accurately predict stock prices!) But the Kasriel model does catch some big moves. In terms of stock price rallies, the Kasriel model does show stocks were undervalued preceding the stock price rallies of the mid 1960s, mid 1970s, early 1980s and early 2010s. And the Kasriel model also shows that stocks were extremely overvalued preceding the stock price declines of the late 1980s, early 2000s and late 2000s. However, significant stock price rallies in the early 1970s, in the early to mid 1980s, in the early 1990s and in the late 1990s were preceded by Kasriel model overvaluations near or above the average overvaluation reading of 36.1%, which again shows that the stock market can stay overvalued longer than you can meet the margin calls on your short positions!

Chart 2

2017:Q3 marks the 34^th quarter in which the S&P 500 stock price index has gone without a quarter-to-quarter decline of 10% or more. In the past 34 quarters, the S&P 500 stock price index has increased at a compound annual rate of 14.0%. The average 34-quarter compound annual rate of change in the S&P price index has been 6.6% in the period from Q1:1964 through Q3:2017. Despite this bull-market run, S&P 500 stocks in the aggregate do not appear to be overvalued in an historical context. Hodrick-Prescott filtered S&P 500 aggregate earnings grew at a compound annual rate of 6.55% in the 34 quarters ended 2017:Q3, which is less than the average 34-quarter compound annual growth in these earning of 7.75% in the period from 1972:Q3 through 2017:Q3. So, the key driver of the theoretical S&P 500 market cap and thus undervaluation or relatively low overvaluation of the S&P 500 in the past 34 quarters has been the low level of the discount factor, the yield on corporate BAA bonds.

Given the low correlation coefficient of -0.20 between percentage changes in the S&P 500 stock price index and the Kasriel model over/under valuation estimates, there obviously are other factors that have significant effects on the behavior of S&P 500 stock prices such as expected government tax and regulatory policies, as well as geopolitical events. Thus, if the S&P 500 stock price index were to plunge 10% or more in the next four quarters or so, it would likely be the result of some factor other than stocks currently being overvalued. (Of course, by writing this, I probably have put the “kiss of death” on the U.S. stock market!)

Paul L. Kasriel

Founder, Econtrarian LLC

Senior Economic and Investment Advisor

Legacy Private Trust Co. of Neenah, WI

econtrarian@gmail.com

The Econtrarian

1-920-818-0236

“For most of human history, it made good adaptive sense to be fearful and emphasize the negative; any mistake could be fatal”, Joost Swarte

∆ + 10 = A Good Life

Wednesday, November 22, 2017

At Least We Can Be Thankful for the 11 "Fair" Traders

November 22, 2017

At Least We Can Be Thankful for the 11 “Fair” Traders

Most of the rest of the world is so unfair to us (U.S.) when it comes to trade. If it were not for this unfairness, perhaps the U.S would rank higher than ninth in the world in per capita GDP adjusted for purchasing power parity (PPP), according to the World Bank.

To see who the “good” and “bad” guys are in terms of U.S. trading partners, I looked through the list of the 41 countries enumerated in my Haver Analytics database that are U.S. trading partners. (This is not a complete list of individual country trading partners, just the list provided in the database I have. For a more complete list, I would have to pay up for the “premium” database.) With these 41 countries, the U.S. ran a trade deficit in goods of $746 billion in 12 months ended September 2017. The U.S. ran a goods trade surplus with only 11 of the 41 countries. That aggregate goods trade surplus was $113 billion. That means that the aggregate U.S. goods trade deficit with the other 30 countries was $859 billion. So unfair!

The 11 countries we ran a surplus with were Hong Kong (less a country than a wholly-owned subsidiary, $31.9 billion), Netherlands ($24.3 billion), Belgium ($14.9 billion), Australia ($13.7 billion), Singapore ($11.0 billion), Brazil ($6.4 billion), Argentina ($4.2 billion), Chile ($2.5 billion), Egypt ($2.3 billion), UK ($1.6 billion) and Norway (less than $0.1 billion). Goods deficits with four countries accounted for almost 66% of the $859 billion aggregate deficit with the 30 countries with which we ran trade deficits in goods – China ($363.2 billion), Mexico ($69.6 billion), Japan ($69.5 billion) and Germany ($63.0 billion). As an aside, while the put-upon U.S. ranks ninth in terms of PPP per capita GDP, as mentioned above, those trade cheaters Germany, Japan, Mexico and China rank 16^th, 22^nd, 61^st and 70^th, respectively. I guess cheaters never really win in the end.

Given our aggregate $746 billion goods trade deficit with these 41 countries, I found it curious that only 11 countries were “fair” traders with us – “fair” as it has come to mean in some circles as countries running a goods trade deficit with us. Could 73% of our trading partners really be cheaters? Then I remembered an “alternative” fact. Namely, if aggregate spending on goods and services in an economy (or household) is greater than the value of goods and services produced in that economy (or household), then, by definition, that economy (or household) must be incurring a trade deficit, in effect, must be borrowing goods and services from the rest of the world.

Are these 30 countries with which we are running goods trade deficits making us run trade deficits with them via unfair trade policies? Not bloody likely! The U.S. persistently runs aggregate trade deficits because its economic sectors – households, businesses and governments – collectively spend more on goods and services than they produce. One possible reason for this is illustrated in the chart below. The green bars in the chart represent the nominal value of goods and services produced in the U.S. economy, nominal GDP, minus the sum of nominal consumer and business spending. The green bars are uniformly in positive territory, indicating that U.S. private sector nominal spending on goods and services has been consistently less than the nominal value of goods and services produced in the U.S. So, why have we run trade deficits during this period? Because of the blue line in the chart – the nominal value of government spending on goods and services. Government sector spending has consistently been higher than the surplus of GDP vs. private sector spending. All else the same, if government sector spending on goods and services were nil, then the U.S. would have been running trade surpluses during this period rather than trade deficits. Alternatively, given the amount of government sector spending, if the structure of U.S. interest rates had been higher and/or the U.S. tax structure had been different so as to encourage more private sector saving (i.e., discourage private sector spending on goods and services), the U.S. might have run trade surpluses rather than deficits.

Trade deficits are not inherently an economic “bad”. It depends on how an economy incurring trade deficits allocates its spending. If trade deficit is run so as to increase spending on physical capital goods and human capital while still allowing for a satisfying amount of consumer spending, then a trade deficit can be beneficial. With the investment in physical and human capital, the economy can grow faster in the future, providing enough extra income to service external debt while not having to curtail future domestic spending. But if the borrowed resources emanating from trade deficits are used to increase household and government consumption at the expense of physical/human capital spending, then the economy’s potential growth will not be enhanced. Therefore, external debt servicing will require a curtailment in domestic spending.

Regardless, as we gorge on Thursday and splurge on Friday, let’s give thanks to the aforementioned “fair”-trading 11.