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The Math of S&P 2200

This post was originally published on Yahoo Finance.

 

 

I want to discuss a meta-theory about how and why the stock market can go higher this year, despite valuations and sluggish growth in the economy and earnings.

 
This theory involves 5 elements:

  1. The investment machinery of Wall Street where trillions of dollars are ear-marked solely for stocks and managers “have to buy”
  2. Extraordinarily low interest rates and a central bank committed to avoiding any action that could lead to recession

  3. Weak global economy and foreign central bank commitments (BOJ and ECB) making US equities the TINA (There Is No Alternative) stars of investing

  4. Quantitative factor investing whose current “Buy, Buy, Buy” input is the premium between the earnings yield on stocks and that of the 10-year Treasury

  5. The dividend yield on the S&P 500 is 2.1%, 50 basis points higher than the yield on the 10-year

 

We define “earnings yield” as the inverse of the P/E, and thus another way of looking at valuations.

So if I say that the current forward P/E of the S&P 500 is 18 because 2075 / $115 EPS, then the inverse is $115 / 2075 or 5.5%.

Thus, 5.5% is the earnings yield of the index. Just like we want “low” P/E ratios, we want “high” earnings yields. They are opposite sides of the same coin and move inversely.

You may be familiar with my #4 element as the “equity risk premium” concept, which is the amount of the excess return that investing in the stock market provides over a risk-free rate, such as the return from government Treasury securities.

This excess return compensates investors for taking on the relatively higher risk of equity investing. The size of the premium will vary depending on the level of risk in a particular portfolio and will also change over time as market risk fluctuates. As a rule, high-risk investments are compensated with a higher premium.

 

 · Great Theory, But What About the Real World of Investing Risk?

 

Lest you think this is some merely theoretical, text-book finance discussion, let me make sure you understand that I also used to think so.

But to Steve Reitmeister goes much credit for being relentlessly focused for many years on the excess premium, or “spread,” between the earnings yield and Treasuries.

Why is this so important?

Let’s look at the attractiveness of this earnings yield compared to alternatives.

Versus a 1.6% yield on the 10-year Treasury, that’s a juicy 3.9% premium.

Is that enough compensation? How much excess premium do institutional equity investors who use quant models really want?

According to Investopedia, survey of academic economists gives an average range of 3-3.5% for a 1-year horizon, and 5-5.5% for a 30-year horizon. Meanwhile, much more conservative CFOs estimate the premium to be 5.6% over T-bills and 3.8% over T-bonds (maturities of greater than ten years).

So it looks like the premium isn’t that juicy after all compared to what professional investors and their advisors say they want.

In the video that accompanies this article, I show a graph of the equity risk premium going back to the early 1960s. The historical average looks like it is actually closer to ZERO! And this is because it often went negative.

In other words, investors have been very accustomed to accepting far more risk for owning equities, and demanding far less premium vs other alternative asset classes like risk-free government bonds.

Remember my #1 real-world “secret” of Wall Street: “they have to buy.” Equity long-only fund managers are in a desperate competition against the benchmark and each other for survival. They can’t sit in cash, so they keep pushing out investments along the risk curve of alternatives.

And since this has worked out quite well for the survivors over many ten-year periods, it’s no wonder they keep doing it.

 

 · The Quant Models Are Pushing Cash — And Everybody Else — Into Stocks

 

You understand the first 3 elements of my meta-theory because I talk about them all the time.

The fourth and fifth additions seal the deal for new highs this year because many investment managers don’t want to think.

They want to use a quantitative model that tells them what to do.

If these large, quantitative, and “competitive” (risk-taking vs. risk-averse) investors keep pushing cash into stocks with relentless flow, they force everybody else in too.

Every short. Every fund manager competing for his breakfast. Every technical break-out trader and momentum hedge fund.

And that is the math of new highs this year, especially after St. Louis Fed President James Bullard suggested on Friday morning that the FOMC may only hike rates once more until the end of 2018.

The Fed has no problem feeding and fueling the stock market wealth effect. They know it’s better than the alternative where a weak market could tip us into recession.

Long live buyers of the equity risk premium!

And be sure to watch the video that goes with this article for all the math and mechanics explained in more detail.

Kevin Cook is a Senior Stock Strategist for Zacks Investment Research where he runs the FTM Institutional portfolio.





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