It has been a while since we did a deep dive into US equity valuations. It isn’t just that the S&P 500 is up 17.5% in 2019 and +12.0% over the last year that gets our attention or that the index trades for 17x forward earnings, a lofty level versus historical norms. US equity market volatility – both actual and forecast – is exceptionally low at the moment. This implies a high degree of investor confidence that every valuation input, macro and micro, is stable and predictable at present.
To assess that sanguine judgment, we will outline bullish and bearish scenarios that both key off the same factors:
- The level and volatility of risk free interest rates
- Corporate earnings leverage and future margin growth
- Earnings quality and capital efficiency
First, here is the upside case using that framework:
#1: Risk free interest rates: central banks and bond markets will discover that the neutral rate of interest is far lower than both recent cycles and their own prior estimates. This is why, for example, US inflation is still below the Federal Reserve’s 2% target despite strong labor markets.
Why is this happening? Higher levels of corporate and private sector indebtedness than historical norms make the US/global economy more levered to the cost of debt. That is why equity markets rolled over so hard at the end of last year, fearing a Fed policy mistake driven by this new dynamic.
As central banks and future economic reports condition fixed income markets to this reality, long-term rates will drop further, boosting equity valuations.
#2: Corporate earnings leverage and future margin growth: S&P 500 net margins have been rising since the 1990s and will either remain stable or continue to improve in the future. The data here:
- Peak net operating margins in the 1990s cycle: 7.5% (2000)
- Peak in the early 2000s cycle: 9.0% (2007)
- Peak in the current cycle: 12.0% (2018)
#3: Earnings quality and capital efficiency: record stock repurchases and rising dividend payments show that the companies of the S&P 500 are able to pay out 100% of accounting earnings, highlighting both high levels of capital efficiency and exceptional free cash flow generation even at mid-cycle levels of economic activity. The data:
- From 2014 to 2018, the companies of the S&P 500 reported net income on an operating basis of $4.2 trillion.
- 40% of that has gone to dividend payments ($1.7 billion)
- 59% has gone to stock repurchases ($2.4 billion)
Pull these points together and the bull case looks like this:...
- Long-term interest rates have further to fall even as economic growth continues. The 10-year Treasury should yield something more like 2.0% if the neutral rate of interest is 1.0%