Wednesday, 14 August 2013

The Odds Stacked in Favour of a Major Stock Market Correction? 10-year Average Earnings- and Dividend Yields, S&P 500 (as of 13 Aug-13)

Earnings - and dividend yields as of 13 August 2013
Based on the closing price of the S&P 500 index of 1,694.16 on 13 August 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):

The 10-year real earnings yield dropped to the lowest level since December 2007, driven by a 1.14% increase in the S&P 500 index since the previous report. The current yield of 4.14% is 30.23% lower than the long term average since 1978 and 33.83% than the adjusted average removing the period 1998 to 2000 (a period of extreme valuations).

The 10-year average real dividend yield also fell since the previous report to hit the lowest level since May 2008. At 1.59%, the yield as of 13 August is 39.84% lower than the average since 1978 and 42.81% lower than the long term average if the 1998 to 2000 period is removed.

The Spread as of 13 August 2013
The spread, calculated as the difference between the 10 year real earnings yield discussed above and the 10 year Treasury Yield, has plummeted during the last four months. Although a declining earnings yield has contributed to the narrowing of the spread, the dominant culprit is the surge in the 10 year treasury yield from 1.76% at the end of April to the current 2.71%. During the last year, the treasury yield has increased 103 basis points, or 61.31%! As a result, equities don't look as attractive relative to the treasury as it did only a few months back. During the last 14 months, we have not put much weight on the spread in reaching a conclusion on stock market valuations in this monthly report as treasury yields have been kept artificially low by the Fed. In fact, in the first issue of this report  in June last year we warned about interpreting the high spread which was around 3% at the time as a sign that equities were cheap,
But be careful with any exact interpretation: the current high spread could be due to a significant over-valuation of long term US treasuries!

In a historical perspective, U.S. equities are expensive based on 10 year average earnings- and dividend yields. In the May and June reports we explained that future long term returns are likely to be poor when current market valuations are high. For the buy and hold equity investor, now is not a good time therefore to be long the S&P 500 index. The following risk factors also should be considered before going long, or continuing to be long, the U.S. stock market:
  • The S&P 500 index is richly priced in a historical perspective based on 10 year average earnings- and dividend yields as discussed above.
  • Other major U.S. stock market indices have surged this year and two are now more than 40% higher than the highs achieved prior to the 2008/9 stock market collapse. 
  • The Wilshire 4500 index, a broad measure of U.S. stocks excluding stocks included in the S&P 500 index, is now trading at a record multiple of GDP (based on data since 1984). 
  • Real earnings for the S&P 500 index declined by 2.4% in Q1 this year compared to Q1 last year according to the data from professor Shiller's website. According to figures released by Factset a few days ago, earnings for Q2 compared to last year appears to be largely unchanged. It therefore appears immediate earnings growth will not be the driver of higher stock market prices.
  • The treasury yield curve is steepening. Rather than reflecting improved economic conditions, it appears it instead reflects expectations that the Fed might sooner or later actually commence its much talked about "tapering" program (given the market reactions to tapering talk by Bernanke). 
  • Money supply and bank credit growth in the U.S. is slowing down. This is especially true for the latter for which the 10 year growth rate recently dropped to an all-time historic low based on data going back to 1983. Banks are simply hoarding their excess cash instead of lending it out, earning 0.25% p.a. at the Fed instead.
  • Net assets in percent of deposits for U.S. banks recently fell to a 7.5 year low. Although the banks have plenty of cash and substantially more so than normal, U.S. banks are more prone to a bank-run today than in the run up to the "credit crunch" in terms of net assets (equity) covering the deposit liabilities.
  • The debt problems in the U.S. and the euro area are still with us and will be for a very, very long time, although they appeared to have been ignored of late. In fact, these debt problems are becoming worse every day as the debt is continuing to grow on both sides of the Atlantic. Any trigger, big or small, will sooner or later bring this back to the front pages. In addition, world markets have Japan's 1 quadrillion yen worth of public debt to ponder.
In conclusion, the list above points to some of the dangers the U.S. stock market (and hence other stock markets) currently face and combined they could signal that the odds are favouring a major stock market correction during the coming weeks or next couple of months. Time will show.

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