Americas CIO View

Equity valuations: many metrics succumb, but earnings yield spreads survive

Out with the absolute valuation metrics and old heuristics. Will they ever return?

The pandemic laid a heavy blanket of negative real interest rates across the curve of the entire developed world, rendering absolute price-to-earnings multiples (P/Es) and other income or cash-flow multiples (or yields) versus history unpredictive of current valuations. It simply killed the usefulness of P/Es vs. history and many other equity valuation heuristics.

Rest in Peace: Market-cap-to-gross domestic product (GDP), Shiller's P/E, Rule of 20 (PE+ CPI rate), Healthy 18 – the post war average P/E ex. high inflation years. Price-to-book and other dinosaur metrics like S&P 500/gold went extinct so long ago they are sometimes whispered like myths. Whereas, now investors cite metrics like dividend vs. Treasury yield (beware it is payout-ratio dependent), or the "Fed Model" of earnings-per-share (EPS) yield less Treasury yields. We point to S&P 500 EPS yield less long-term Treasury Inflation Protected Securities (TIPS) yields as best indication of an offered equity risk premium. This metric is improved when based upon estimates of both cyclically normalized S&P 500 EPS and TIPS yields. But it still leaves long-term economic profit growth potential (or decline) unaddressed, a consideration more important today given the S&P 500’s compositional shift toward growth industries and for properly comparing growth vs. value market segments. Yet, through the ages, robust discounted-cash-flow (DCF) frameworks still work by encompassing all value drivers.

Will negative real interest rates last many years, a decade, or just a few years?

The fair and sustainable S&P 500 P/E depends on where and when long-term real risk-free interest rates normalize. We monitor 10 through 30-year TIPS yields for indications of normal long-term real yields. Despite a rapid recovery in S&P 500 EPS led by growth stocks and recently banks, and so far a good U.S. GDP recovery in progress with expectations of better service consumption and thus jobs recovery later this year, 10-year TIPS yields remain near pandemic and all-time lows of -1%. If this is the new norm for 10-year TIPS, persisting through the decade, we would consider a 25 P/E on mid-cycle S&P 500 EPS fair. But because we expect 10-year TIPS yields to move to 0.0% in a few years, we think 21.5x is a fair trailing P/E on non-generally accepted accounting principles (GAAP) S&P 500 EPS. Our 4,000 S&P 500 2022 end target is 21.5x our 2022E (estimated) non-GAAP S&P 500 EPS of 185 dollars, which assumes no corporate tax hikes. We still adjust our fair P/E estimate for persistent shortfalls in GAAP EPS from non-GAAP EPS, perhaps another dinosaur fossil.

How will the government pay for its pandemic aid? This will affect interest rates

The cost to the Federal government of cushioning the economic damage the pandemic dealt businesses, households and local governments, schools, non-profits will exceed 4 trillion dollars. This likely produces some combination of modest to moderately higher inflation, modest to moderately higher real interest rates, and modest to moderately higher taxes than what otherwise would have been the case over a long future period of time, perhaps a decade. This is a constructive and reasonable scenario within the abilities of policy, but uncertain.

Because we see political and economic challenges to large tax hikes or spending cuts, we think much of the burden will fall on inflation and real interest rates. It will depend on monetary policy how much burden falls onto inflation (nominal asset savers, but also economic efficiency and effective price signals) vs. real interest (borrowers and also the value of income producing real assets). We think the dangers of overly accelerating inflation are well understood by monetary-policy setters. Trying to fight rising yields on rising inflation expectations with additional asset purchases or keeping overnight rates at 0% too long will only further raise inflation expectations/risk and yields. We believe long-term real interest rates will eventually rise to 0% on elevated government debt and because we think 0% is the natural real risk free rate likely to prevail when inflation is at its desired target.

EPS reports: fourth quarter bottom-up climbs to 38.60 dollars, reserve release at banks adds 0.75 dollars

Fourth-quarter earnings season starts strong with banks beating on booming capital markets and loan loss reserve releases. The 13 banks that reported released 6.4 billion dollars of reserves, which boosted bottom-up fourth quarter S&P 500 EPS by 0.75 dollars. This contributed half of the S&P 500 EPS climb in the first two weeks of reporting. Large reserve releases caused negative loan loss provisions of -1.7 billion dollars, i.e. a profit boost. Total loss reserve as % of total loans dropped from a 2.55% peak in the third quarter to 2.30% in fourth quarter, but still nearly twice the 1.2% level before the pandemic. Where fourth-quarter EPS finishes is uncertain. If remaining companies beat by 3% to 5% in aggregate, as is typical in the past and as we expect, then the fourth quarter will be about 40 dollars. But if beats are 10%+, like the last two earnings seasons, then the fourth quarter could finish at 42 dollars. Suggesting annualized S&P 500 EPS power as of fourth quarter of 165 dollars. Our 170 dollars 2021E S&P 500 EPS has some upside in latter case.



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