Wednesday, 6 November 2013

The Best is Behind Us in This Cycle...: 10-year Average Earnings- and Dividend Yields, S&P 500 (as of 5 Nov-13)

...and the worst is yet to come.


Earnings - and dividend yields as of 5 November 2013
Based on the closing price of the S&P 500 index of 1,762.97 on 5 November 2013 and data from Professor Robert Shiller's home page, the current 10-year average real earnings- and dividend yields for the S&P 500 index are as follows (please refer to the June 2012 analysis for background information):


Earnings- and Dividend yields as of 5 November 2013
The 10-year average real earnings yield decreased 3.70%, or 16 basis points, from that reported last month to 4.09%, the lowest reported since December 2007 (3.85%). The earnings yield declined primarily due to the S&P 500 surging 4.29% during the same period. As a result, the earnings yield is now 30.90% lower than the average since 1978 and 34.43% lower than the adjusted average since 1978 (which excludes the 1998-2000 period when market valuations were extraordinary high).


The 10-year average real dividend yield also declined during the last month due to the surge in the S&P 500. At 1.55%, it dropped 4.03% (7 basis points) compared to last month, resulting in the lowest yield reported since January 2008 and 41.15% lower than the average since 1978. Removing the 1998 to 2000 period, the current yield is 44.03% lower than the adjusted average.


The Spread as of 5 November 2013
The spread, the difference between the 10-year average real earnings yield and the 10-year U.S. treasury yield, narrowed by 9.83% (16 basis points) during the month to end on 1.44% yesterday. This narrowing of the spread was driven by the surge in the S&P 500 which drove the earnings yield lower. The 10-year treasury yield was unchanged from last month. The spread remains high in a historical perspective, a direct result of an artificially low treasury yield rather than a high earnings yield.




Conclusion
Having remained fairly flat during the prior three months or so, the S&P 500 index shot up 4.29% during the last month setting new all-time highs in the process.

Based on the real (CPI adjusted) value of the index as calculated by Professor Shiller, now a Nobel laureate (read my views on the award here), the index is up some 24% during the last year. Meanwhile, 10-year average real earnings and dividends increased 6.05% and 4.42%. The majority of the price increase during the last year was hence driven by an expansion of the earnings multiple which increased by 16.94%. This only adds to my view that the stock market is approaching a peak.

Yes, the P/E multiple could of course expand further from here, but over the longer term stock market prices need to be supported by fundamentals as an increase without it is unsustainable and will eventually result in a correction. My view, more so now than in previous months, is that the stock market is richly valued. Buying the S&P 500 index now is therefore not a winning recipe if you are a long term buy and hold investor.

Here are some of the key stock market indicators I follow for the U.S. stock market in addition to the analysis above. All of them are in my opinion flashing danger ahead for stock market prices or at best signalling that the biggest upward movements in prices are behind us in this cycle:

  • Wilshire 500 Index to GNP Ratio ("Buffett's favourite valuation chart", as of 4 November 2013: 

  • Wilshire 4500 Index to GDP Ratio (current and 10-year rolling), as of 4 November 2013:

  • The S&P 500 Index and the St. Louis Fed Financial Stress Index, as of 5 November 2013:

  • 10-year average real earnings growth, S&P 500 Index (YoY % change), as of 5 November 2013:

  • Performance of major U.S. stock market indices this year and compared to pre-Lehman peaks:

  • M2 Money Supply and Bank Credit growth is slowing down, as of 16 October 2013 (click here for the most recent report):

Finally, do not for one minute think the debt problems in the U.S. and Europe have disappeared. In fact, the debt situations in both areas have never been worse than they currently are, at least in modern times. This will have negative repercussions for the economy going forward, one way or another. As an investor, the Fed and other central banks are of course on your side and will do what they can to support stock prices going forward as well. But in the end, the market always wins.  

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A note on "Earning Power"
The market is from time to time more concerned with the movement of the share price itself, rather than the underlying fundamentals that underpin value over the longer term. Ultimately, fundamentals will get the attention of the market once expectations are not met. Being ahead of the market in such respects may yield satisfactory results. I think we are closing in on such a moment these days. 

As the P/E multiple expands, the pressure on company management to deliver ever growing earnings increases. Such pressure inevitable leads to a temptation to manage earnings and hence to report less conservative earnings resulting in lower quality earnings. In some cases such pressure also leads to outright manipulations of earnings, e.g. Enron. 

When the next crisis hits, which it will, prior overstated earnings will be corrected through large write-offs of inventory and other assets - "big bath" accounting. This is the major reason why it makes sense to look at earnings over the credit (business) cycle (e.g. the 10-year averages used in this report), instead of purely focusing on the most recent or next year earnings. Graham and Dodd explained "earnings power" as follows in 1940,
The concept of earning power has a definite and important place in investment theory. It combines a statement of actual earnings, shown over a period of years, with a reasonable expectation that these will be approximated in the future, unless extraordinary conditions supervene. The record must cover a number of years, first because a continued or repeated performance is always more impressive than a single occurrence and secondly because the average of a fairly long period will tend to absorb and equalize the distorting influences of the business cycle. A distinction must be drawn, however, between an average that is the mere arithmetical resultant of an assortment of disconnected figures and an average that is “normal” or “modal”, in the sense that the annual results show a definite tendency to approximate the average.
Security Analysis, 2nd ed. 



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