Volatility Returns Update – Finding Fair Value

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Read the rest of the series here:
Volatility Returns – Exploring the Reasons and What Happens Next
Volatility Returns Update – Markets Enter Correction Territory.

The S&P 500 Index officially entered “correction” territory, defined as a 10% decline from the prior peak, on Thursday, February 8 when the index closed at 2,581, -10.16% below its January 29 all-time high of 2,873. Intraday, it fell as low as -12% below its all-time high. While the correction has been jarring, given its rapid pace, it was somewhat inevitable after the year-plus period of historical calm that preceded it. What was surprising was its swiftness, as it was the fastest 10%+ drop from an all-time high ever recorded.

I do not believe this is an economic event and therefore do not believe we are headed for a bear market now. We probably have, however, witnessed the flex point for the following:

  • The Fed is “definitely” done providing the liquidity for increased asset prices; increases will occur by more “normal” market forces
  • Non-U.S. central banks will be less involved in “juicing” their economies and financial markets
  • Commodity prices have put in a long-term bottom
  • The periodic worry about “deflation” is over; now inflation retakes center stage, but we do not see a worrisome amount
  • U.S. 10-year interest rates should now see a trading range of 2.60% to 3.35%
  • Fed funds probably increase 3 times in 2018, ending the year at 2.00-2.25% or higher
  • U.S. corporate earnings will be better than forecast, as the tax cuts remove a huge “expense” from corporate P&L’s and amaze both CFO’s and investors

The Charts

Market corrections are not uncommon events. The chart below shows the draw-downs of the S&P 500 index since the start of the Bull Market back on March 9, 2009.

S&P 500 Drawdowns - March 9, 2009

It is important to take a longer term view of the markets when trying to gain a clear perspective on the recent turbulent sell-off in the markets. In the below chart of the S&P 500 we draw a long-term trendline (green), today showing a price of 2450, and the 200-Day Moving Average (DMA) (blue), today coming in at 2540. These “lines” show strong support at levels just below recent low prices hit.

S&P 500 Large Cap Index - 2018

In the next chart, starting at the end of 2016, we add an intermediate-term trend-line (purple) to the long-term trend-line (green) from 2009 and the 200-DMA (blue), all showing strong support at prices not too far below the recent lows.

S&P 500 Large Cap Index - End of 2016

Focusing on an even more short-term view of six-months we can get a clear picture of the recent market action. Friday’s (February 9) candlestick hit the 200-DMA (blue) and bounced, finding meaningful support. Also, important to note is that we saw positive follow through from Friday’s bounce on Monday, February 12th, which bodes positively for the markets.

S&P 500 Large Cap Index - Feb 2018

Markets are trying to find a floor here, but we could go lower if support at the 200 DMA were to break. Regardless, pullbacks and corrections are common during prolonged bull markets.

The Valuations

Valuation of the S&P can be a tricky subject. One could argue that the market is efficient and the current price at a given moment is the “fair value”. This ignores the human emotion factor, which we know can be extremely irrational, particularly in times of market euphoria or stress. One way to gauge the over or undervaluation of the market is to apply a discounted cash flow approach. Warren Buffet says it’s his favorite “market valuation” measure. When an investor buys a stock, they are essentially paying in advance for the company’s future earnings. Valuing an index, in this example the S&P 500, is the same – the current value of the index should reflect the present value of the future earnings we expect the index to generate. We need just a few inputs to analyze the index; an anticipated period 1 payment (the S&P 500 Index net earnings), a perpetual earnings growth rate estimate (how much will those earnings grow over time), and a discount rate (the rate of return an investor expects in order invest their capital in equities) comprised of the risk-free rate plus an equity market risk premium.

2018 S&P 500 Index earnings forecasts have been trending upward, reflecting the impact of the tax reform legislation, and currently are estimated at around $145. This is our first input, the period 1 payment. Next, we need to estimate the rate at which we can anticipate this payment to grow in future years. We should look at historical S&P earnings data, which is available all the way back to 1871. Historically over the entire period, S&P earnings have grown at an average annual rate of roughly 5%. Since 1950 that rate has been a lot closer to 7%. Therefore, we will apply a 6% estimated growth rate to our $145 2018 earnings. The final component is a discount rate. This data is available from Bloomberg, and as of this writing is 10.30%, arrived at by combining the risk free 10-year Treasury rate of 2.85% plus an equity market risk premium of 7.45%. Meaning investors are requiring a 10.30% rate of return to compel them to invest in stocks today.

Using the above inputs, we use the following simple formula: Period 1 payment divided by (Discount Rate – Growth Rate) or $145 / (10.30% – 6.00%). This formula yields a present value of 3,370 for the S&P 500, roughly 27.5% above February 12th’s opening value of 2,643. If we modify the inputs to grow our future earnings at a slower rate, using 5%, the present value of the S&P 500 drops to 2,734, just 3.5% above 2,643. Given the recent trend in earnings growth, we feel it is reasonable to assume that earnings will exceed 5% in the coming years, which would indicate that perhaps the recent selloff was somewhat overdone. We also could revise the discount rate, because as interest rates rise, so does the risk-free rate, and therefore with a constant risk premium applied to equities, the discount would then rise in proportion to the risk-free rate. The table below provides some scenarios.

Valuation Scenarios. (Data: Bloomberg, Standard & Poor's)

Valuation Scenarios. (Data: Bloomberg, Standard & Poor’s)

Concerns over interest rates have been instrumental in the recent market selloff. While rates have been rising on higher expectations for inflation, we do not think that rates will continue to rise in dramatic fashion. In the chart of the U.S. 10-Year Treasury yield going back to 2013, we see a 3% topside target in place, with resistance to a further rise above that level.

CBOE 10-Year U.S. Treasury Yield

In addition to this technical resistance around 3%, we see some additional reasons that interest rates will stabilize.

  1. Interest rate-sensitive stocks, like utilities, have started to find bids after the strong sell off.
  2. The U.S. Dollar is off recent lows and should help U.S. bond markets as relatively attractive yields entice international investors, with less worry about a falling dollar to hurt their capital.
  3. Developed market sovereign debt has decoupled from the U.S. in terms of yields since 2012-’13, with the U.S. debt yielding significantly more than international alternatives. Given the United States’ top tier credit rating, there should be some continued buying from global investor demand, thus providing a possible governor keeping U.S. rates from rising too far.

10-Year U.S. Treasury Yield

Another major unresolved question, which will not be answered for several years, is the ultimate impact of the 2017 tax cuts. The U.S. will be increasing deficits and issuing additional debt – as much as $1 trillion in 2018 – possibly pressuring interest rates to go higher. The promise of the tax bill, of course, is that businesses will flourish under the lower tax burden, boost U.S. GDP, and an associated increase in U.S. tax receipts will occur.

Clearly, both equity and fixed income markets are still trying to sort things out, and are hovering around key technical levels. The economic data remains strong and is a clear argument against the start of a bear market. The charts are also suggesting this pullback is encountering support near these current price levels, but there could be more short-term volatility and downside. As always, we will use all the tools at our disposal to continuously monitor the markets for you.

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