April 2, 2018
As of this Past Fourth Quarter, the
S&P 500 Remained Relatively Cheap
Now that the first quarter of 2018 has just ended, what could
be more fitting than to look back at the relative valuation of the S&P 500
stock index as of last year’s fourth quarter? After all, isn’t that what we
economists do best, look back? This
commentary is an update to my November 29, 2017 commentary, “The S&P 500 Is Not
Expensive According to the Kasriel Valuation Model”. Before reviewing my
methodology for estimating the over/under valuation of the S&P 500 stock
market index, let me give you the Q4:2017 results upfront. According to my
methodology, the S&P 500 index in Q4:2017 was overvalued by 7.4% compared
with a revised 4.1% overvaluation in Q3:2017. Given that the median value of
over/under valuation of my methodology in the period Q1:1964 through Q4:2017
was 35.5% overvaluation, the 7.4% overvaluation of the S&P 500 in Q4:2017
seems trivial. The continued low level of the corporate bond yield is the
principal factor keeping the S&P 500 from being more materially overvalued.
Now for the important disclaimer. My
relative valuation methodology involves only three observable variables –
smoothed annualized reported earnings of corporations included in the S&P
500 equity index, the level of the corporate BAA/A-BBB bond yield and the
actual market capitalization of the S&P 500. My methodology does not take into consideration expectations of corporate earnings or of
bond yields. Nor does it take into consideration exogenous “shocks” including
but not restricted to the likelihood of changes in the U.S. tax code, of geopolitical
conflicts or of the imposition of U.S. trade protectionist policies. Of course,
if I had a high degree of certainty about these exceptions to my “model”, I would
be an extremely wealthy person and would not be inclined to share my “wisdom”
with you!
To refresh your memory about my methodology, I calculate
a quarterly theoretical market
capitalization for the S&P 500 by discounting (dividing) smoothed annualized reported earnings of
S&P 500 corporations by the yield on the lowest-rate investment-grade corporate bonds (BAA/A-BBB). I then compare my
calculated theoretical market capitalization value with the actual market capitalization value. The
percent of over/under value for the S&P 500 is calculated as follows:
((Actual Market
Cap/Theoretical Market Cap)-1)*100
The technique I use to smooth reported corporate earnings is some high-falutin’
econometric technique called the Hodrick-Prescott filter. (Edward Prescott is a
Nobel Prize winner in economics.) This smoothing technique is designed to
remove the cyclical variation from a trending series. Another economics Nobel
Prize winner, Robert Shiller, uses a 10-year moving average to smooth the
S&P 500 price-to-earnings ratio in his stock market valuation research. He
calls this the cyclically-adjusted
P/E. It seems to me that a 10-year moving average is an arbitrary tool to use
to remove the cyclical component from a time series. Why not use a technique
specifically designed to remove cyclicality? While I’m on the subject of the
Shiller cyclically-adjusted P/E, aside from the arbitrariness of using a
10-year moving average, a P/E in
isolation tells you nothing about the stock market’s over/under valuation
without taking into consideration the level of bond yields. A low P/E could be
an indication of an overvalued stock market if the bond yield is relatively
high. Conversely, a high P/E could be an indication of an undervalued stock
market if the bond yield were relatively low, as has been the case for several
years now.
Let’s go to the data. Plotted in the chart below are the
quarterly observations of the percent over(+)/under(-) valuation of the S&P
500 calculated with my methodology discussed above. Also plotted in the chart
are quarterly observations of the year-over-year percent change in the S&P
500 equity index. If my methodology has any legitimacy, there should be a negative
correlation between the over/under valuation variable and the year-over-year
percent change in the S&P 500 index. That is, if the S&P 500 is
overvalued as calculated by methodology, then I would expect the S&P 500
equity index to be increasing at a slower rate or even declining. I found that
the highest absolute value of a negative correlation coefficient, minus
0.20, is obtained when the over/under valuation is advanced by five quarters
in relation to the year-over-year percent change in the S&P 500 index. (With the low value of the correlation
coefficient at minus 0.20, there obviously is a lot missing from this “model”
in terms of explaining the behavior of the stock market, as I admitted at the
outset.) So, the last data point plotted in the chart for the over/under
valuation variable at Q1:2019 is actually the observation for Q4:2017 (advanced
five quarters). The median value of over/under valuation is 35.5%. So,
interpreting whether the S&P 500 is over or undervalued, it is better to
look at the percent over/under valued in terms of 35.5% rather than zero.
As of Q4:2017, then, my “model” indicated that the S&P 500 was
overvalued by 7.4% -- a relatively low reading in comparison to the 35.5%
median value for over/under valuation during the entire sample period. The
yield on the BAAA-BBB corporate bond yield appears to have averaged about 4.45%
in Q1:2018, up about 18 basis points from its Q4:2017 level. The market cap of
the S&P 500 was about $22.5 trillion. If annualized smoothed S&P 500
reported earnings remained at their Q4:2017 level of $906.7 billion, then the
S&P 500 would be 10.4% overvalued in Q1:2018 – still well below the median
overvaluation of 35.5%. What if the BAA corporate bond yield had risen 100
basis points in Q1:2018 to a level of 5.27% and annualized smoothed reported
S&P 500 earnings remained the same as they were in Q4:2017. In this case,
in relation to the actual S&P market cap in Q1:2018, the S&P 500 would
have been 31% overvalued. Of course,
if the bond yield had risen by 100 basis point in Q1:2017, it is likely the
actual S&P 500 market cap would have been significantly lower, and thus,
the overvaluation of the market would also have been lower.
In sum, given S&P 500 annualized smoothed reported
earnings and the current level of corporate bond yields, the S&P 500 stock
market does not appear to be excessively overvalued. The continued low level of
corporate bond yields is the principal reason that the overvaluation of the
S&P 500 remains low in an historical context. Corporate earnings are
growing, but at a subdued pace. In full disclosure, my portfolio is devoid of
equities even though I do not believe that the S&P 500 is grossly
overvalued. Why? Because of those other
factors that I mentioned earlier in this commentary. As evidenced by the quote
I put at the end of my commentaries -- for
most of human history, it made good adaptive sense to be fearful and emphasize
the negative; any mistake could be fatal – I am congenitally risk averse.
The S&P 500 equity index exhibited increased volatility in Q1:2018. I
believe that this increased volatility was due primarily to exogenous “shocks”
mentioned earlier in this commentary rather than the behavior of corporate
earnings and/or corporate bond yields.
Paul L. Kasriel
Founder, Econtrarian, LLC
Senior Economic and Investment Advisor
“For most of human
history, it made good adaptive sense to be fearful and emphasize the negative;
any mistake could be fatal”, Joost Swarte
∆ + 6 = A Good
Life
