Monday, August 31, 2015

Crystal Ball Gazing on Stock Prices and What the Current 'Earnings Yield' Implies About Future Returns ... Total Returns on Blue Chip Stocks (Share Price Plus Dividends) May Exceed 50% Over the Next Five Years ... Low interest rates, Low inflation and a Continuously Improving U.S. Economy Should Make That Happen.

After a horrible beginning, stocks rebounded off their lows late last week. They appear to headed lower again today, and the month of August will end up being a definite loser for stock investors.

Still, count me in as an unwavering long term optimist, as the real investment gains are measured in years and decades rather than days, weeks or months.

Many market pundits are saying that it's time for a big market 'correction,' aka fall, as stock prices are greatly overvalued at current prices. My crystal ball disagrees, and I definitely can envision prices headed substantially higher over the next several years.

That said, I certainly don't know, nor is it even knowable, where share prices are headed in the short term. And anybody who claims to have such knowledge about the short term direction of the market is wrong. Yet they keep trying. See Some Stock-Market Experts Still Bracing For More Trouble.

Here's what I think. Long term oriented investors can anticipate with some reasonably high level of confidence that total returns (price appreciation plus dividends) will grow by ~50% from today's levels in the next five years.

And the reasons for this admittedly optimistic assessment are simple: (1) interest rates and inflation rates will remain low even after the Fed raises them from their current basement level, and (2) the American economy will continue to strengthen, as will the sales and earnings of well run companies. With that simple set of assumptions in mind, let's explore why it's realistic to expect that share prices are headed higher the next several years.

First, realizable gains in stock prices over the long haul are a result of share price growth from (1) actual increases in earnings, (2) valuation due to a price to earnings (PE) multiple expansion, and (3) cash dividends. Another critical ingredient is the comparison of the 'earnings yield' on stocks to the expected interest rates on bonds (fixed income yields). We'll look at the earnings yield factor today.

When valuing stock prices on a fundamental basis, a good checkpoint is to compare the current and expected ten year U.S. treasury bond yield plus the estimated inflation rate to the 'earnings yield' on stocks. So let's see what that simple analysis reveals about the outlook for stock prices.

U.S. Blue Chips With Fat Dividends Offer Value is Barron's cover story this week. It has this to say about the attractiveness of blue chip companies' stock prices today because of the 'earnings yield' of these high yielding dividend paying blue chip stocks in a low interest rate environment:

"While stocks, as measured by the S&P 500, aren’t cheap by historical standards at a current 16 times forward earnings, they aren’t expensive, either. The earnings yield, the inverse of the price/earnings ratio, is 6%, or more than 2.5 times the yield on the 10-year Treasury bond."

Using the S&P 500 as a proxy for the market as a whole, stocks are priced at 1,989. Estimated earnings for the S&P 500 for next year are ~$120. 1,989 divided by 120 equals 16.

The current PE (price to earnings) multiple for the index is therefore 16. Here's another way of looking at the same thing: the earnings yield, aka the reciprocal of the PE multiple, is 6%. (120 divided by 1,989 equals ~6%.

Now let's compare that to the current bond yield of 2.18% for ten year government bonds.

2.18% is much lower than 6%, so that implies that stock prices aren't overvalued today. It also implies that if the Federal Reserve is successful at getting inflation up to 2% from its current ~1% level, then the estimated future government bond yield would be 4% ( 2% targeted inflation + 1% to 2% real return on government bonds = 3% to 4%, so we'll assume 4% for comparison purposes.).

A 4% interest rate is one third lower than the current earnings yield of 6%. On that measure alone, stocks remain attractively priced today. In fact, if the S&P 500 index were to climb to 2,400, or 20% higher than its current price, and S&P index earnings reach ~$120 next year as anticipated, then the earnings yield would decrease to 5%, but still a favorable indicator for higher share prices.

Thus, I'm not going to worry about prices being too high as long as I believe that interest rates will stay low. And thanks to energy prices and a strong U.S. dollar, it's reasonable to expect inflation to stay around 2% for some considerable time to come.

In other words, for the foreseeable future interest rates on ten year treasuries will be lower than historically has been the case due to continuing low inflation and low commodity prices attributable to a strong dollar and a weakened China.

To repeat, we arrive at a fair value PE of 20 by using 5% as the new 'normal.' Of course, using a less conservative 4% would indicate a fair value PE of as high as 25.

Accordingly, S&P 500 earnings of $120 point to a fair value of between 2,400 and 3,000. Today we sit at ~2,000.

In addition, higher earnings over time will increase the earnings number from $120 to perhaps $160 within five years. This valuation adder will more than offset unforeseen modestly higher future interest rates and still get us to that 3,000 neighborhood, despite an unexpected increase in interest rates.

And that's why I don't believe the market is overvalued today. To the contrary, my view is that it still has 'miles to go before it sleeps.'

So while I'm not predicting a moon shot, neither am I expecting a substantial fall in share prices over time. And I do expect PE multiples to stay higher than 'normal' instead of contracting in this forecasted low inflation and low interest rate environment for the next several years.

Meanwhile, increasing cash dividends on blue chip stocks will keep on coming and grow consistently over that time as sales and earnings increase.

But here's the closer: even if I'm wrong, I'm a long term individual investor who is in it for the long haul.

That means I won't be scared out and unduly troubled when encountering the inevitable volatile trading periods during the next several weeks, months and years.

Math class is over for now, but that's my take.

Thanks. Bob.

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