September has proven to be a challenging month for investors, as the S&P 500 experienced a significant drop of 5.3% within just 18 trading days, plummeting from 4,516 to 4,275.
The primary culprit behind this market turmoil appears to be the sudden surge in long-term interest rates, notably the 10-year Treasury yield, which soared by nearly 50 basis points to 4.55%.
However, despite these unsettling developments, Wall Street remains surprisingly optimistic about the market’s future, with firms like Goldman Sachs and Citigroup maintaining relatively bullish forecasts.
In this article, we delve into the market’s current dynamics and explore why the math behind these bullish predictions might not add up.
The Bullish Case:
The prevailing optimism on Wall Street hinges on analysts’ earnings projections for the coming quarters.
According to these forecasts, trailing 12-month GAAP profits are expected to rise from $200 per share in the first quarter to $230 per share in the second quarter of the following year.
If this scenario plays out, it could lead to the S&P 500 reaching over 4,800, even at a modest price-to-earnings (PE) ratio of 21x by next summer.
The Skeptical Perspective:
However, a closer examination of the market’s fundamentals reveals a different story. Corporate earnings are known to be highly cyclical and erratic, often subject to extreme fluctuations.
To address this issue, Nobel Prize laureate Robert Shiller developed the Cyclically Adjusted Price-Earnings ratio (CAPE), which smooths earnings data over a 10-year period, providing a more stable view of earnings potential.
Currently, the CAPE EPS stands at $145, with some experts adjusting it upwards to around $160 to account for inflation.
Taking this into account, it becomes evident that earnings are more likely to trend downward toward $160, rather than upward, as predicted by the bullish camp.
To assess a reasonable valuation for the S&P 500, we need to consider the real yield on the 10-year Treasury, which has risen substantially. High real rates make fixed-income investments more appealing, causing equities to lose their attractiveness.
The Equity Risk Premium (ERP), which represents the premium investors demand to choose equities over risk-free assets like Treasuries, typically averages around 3.5%.
Combining this with the real yield of 2.37% on TIPS and accounting for inflation, the best estimate for future stock returns is approximately 5.9%, corresponding to a PE ratio of roughly 17.
The Implications:
If we apply this multiple to the “normalized” earnings estimate of $160, the resulting S&P 500 value is 2,720.
This is a stark 43% lower than the level observed on September 26. While a 40% decline might not be inevitable, the mathematics behind this scenario suggests that a significant correction is a distinct possibility.
In summary, the recent spike in long-term interest rates, coupled with historically high PE multiples and profit margins, has created a situation where a market correction seems plausible.
While market sentiment may remain positive, it’s essential to consider the fundamental mathematics that underpin stock valuations.
The trajectory of real interest rates and the sustainability of corporate earnings will likely play a crucial role in determining the market’s future course.
As investors, it’s prudent to approach the current market landscape with a healthy dose of skepticism and a keen understanding of the math that drives it.