- The fight between interest rates and stock valuations has started.
- The only smart thing to do now is to take a long-term perspective and estimate what financial markets will look like in two years. Few think that way.
- Corporate profits in relation to GDP tell you what will happen in the long term.
Last Wednesday, the FED released the minutes from its latest meeting. Soon after the minutes were published, the market went into reversal mode.
The market action tells me that the fight between higher interest rates and stock market valuations has started. It’s something difficult to balance as the following questions have to be answered:
- Will the earnings growth cover for the adjusted risk expectations?
- Will the FED manage to balance economic stability and growth and prevent inflation spikes?
- Are stocks too risky with an earnings yield of 4% in relation to bonds yielding above 2%?
- If the FED hikes interest rates another 5 times in the next year and a half, will bond yields be above 4% given the federal funds rate at 2.5%?
- Consequently, will the required return from stocks be 6%, implying a 50% market decline?
That’s a lot of questions, but I have great news for you. The market is scared to act decisively, this means that no one is going to adjust to lower valuations in one day. Thanks to the market’s short-term orientation and inertness, we can position ourselves accordingly to what the most likely outcome will be.
Let’s take a look at what the FED is thinking and then see what can we do about it.
The FED’s Minutes
The key of the minutes is on page 16 where the participants “anticipated that the rate of economic growth in 2018 would exceed their estimates of its sustainable longer-run pace and that labor market conditions would strengthen further.” This is supposed to lead to further gradual interest rate adjustments where the most likely scenario is 3 hikes in 2018 and two in 2019 for now. This would see the federal funds rate at 2.75% in 2019 which would change a lot of things.
Federal Funds Rate At 2.75%
A federal funds rate at 2.75% would bring the 10-year treasury to around 4%. The increased budged deficit and loose fiscal policy certainly doesn’t help in keeping bond yields low. So if the risk-free asset and perhaps the least risky asset in the world yields 4% per year, what should the required return from stocks be?
Let’s say that stocks should at least give a 6% earnings yield where the 2% spread covers for the increased risk equities carry (a small spread in historical terms). The current S&P 500 earnings yield is 4% as the price to earnings ratio is 25.
For a 6% yield at constant earnings, the S&P 500 should have a PE ratio of 16.6. If we multiply 16.6 with the current S&P 500 earnings level of 106.95, we get an S&P 500 value of 1,782. Thus, just from what is most likely to happen, stocks should fall 35%.
This decline can be mitigated by earnings growth but given that interest rates are increasing and the unemployment rate is extremely low, doing business for corporations will become more difficult. Therefore, earnings of 162 for the S&P 500—which would require a 50% growth rate, or 22% per year—in a tougher business environment, a 22% yearly growth rate will be difficult to achieve even if the economy does well.
On the other hand, if the FED doesn’t increase interest rates due to the economy not growing as fast as expected, S&P 500 earnings will again suffer. So the story for equities is a lose-lose situation in the medium term. What we are seeing with the recent increases in volatility are the first glimpses of this fight between corporate earnings, higher required returns in the form of higher equity risk premiums, and higher interest rates.
Today, I will conclude with something that will give you food for thought. The GDP share of corporate profits.
Corporate Profits Are A Bigger Part Of GDP
In 1999, Warren Buffett said that he doesn’t see how it’s possible that corporate profits remain above 6% of GDP for a longer period of time.
At some point in time, and perhaps this is exactly what we are seeing now with higher growth in wages, those corporate profits are bound to revert to the mean because if that doesn’t happen, there could be lots of trouble down the way.
A look at historical profits to GDP ratios will show you how corporate profits are always volatile. So expect them to be the same in the next 10 years.
I’ve given you the short and medium-term outlook for things but also the long-term view. I hope you consider what’s going on from a longer-term perspective and make the right decisions for your portfolio and financial wellbeing.