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Is There A Mounting Risk to US Equity Valuations?

May 18, 2018

The sell-off in US treasuries has pushed the yield on the US 2-year note to 2.547%, representing a 66 basis points increase for the US 2-Year YTD. Further along the Treasury curve, the yield on the US 10-year bond has risen nearly 65 basis points to 3.056% YTD.

 

 

But Why Do You Care?

Stock valuations are inextricably linked to bond yields. The denominator of the famous Gordon-Growth Model, the grand daddy of all valuation models uses a Discount Rate minus Growth in its denominator (as does any Free Cash Flow and Retained Earnings models!). The discount rate is derived, using traditional CAPM, with the following formula:

  • Risk Free Rate + Beta * (Expected Return of Stocks – Risk Free Rate)
  • The Risk-Free Rate is normally either the US 2-Year Treasury Note or the US 10-Year Bond.   Now is it making sense?  If US government bond yields go up, the discount rate applied to stock valuation goes up, which will cause valuations for stocks to decline all else equal.

Are Stocks Really Too Expensive?

If we simply look at dividend yields, the answer may be yes.  The gap between the S&P 500’ s Forward 12-month (F12M) dividend yield and the yield on the US 2-Year Treasury Note has turned to a negative 50 basis points.

 

 

Similarly, the spread between the S&P 500’ s F12M dividend yield and the yield of the US 10-year treasury bond is now a negative 103 basis points.

 

 

Earnings Yield as a Barometer of Value

While simply looking at the F12M dividend yield of the S&P 500 would suggest equities may be overvalued, we think that would be the wrong conclusion.  Here at Quantamize, we believe that the F12M earnings yield is a better barometer of value than the F12M dividend yield. At present, the S&P 500’s F12M earnings yield is sitting at 6.00% which is a premium of 345 basis points to the US 2-Year Treasury Note and a premium of 294 basis points to the US 10-Year Treasury Bond.

If the spread between the F12M earnings yield on the S&P 500 and the yield on the 2-year as well as the spread between the F12M earnings yield on the S&P 500 and the yield 10-year narrow, does that mean US stocks will sell-off? We don’t think things will be that simple. 

When determining whether US stocks are overvalued relative to bond yields, we prefer to first consider the Yardeni Model.  The Yardeni model relates the warranted earnings yields on a stock to the average Yield of the Moody’s AAA Corporate index adjusted for earnings growth.

If the spread between the ACTUAL F12M earnings yields for the S&P500 and Yardeni-derived earnings yield is positive, the model implies that the S&P 500 is not overvalued.  But is that enough to prevent a correction in valuations?

 

Earnings Growth Driving Valuation

Earnings results in the S&P 500 in 1Q2018 have been stronger than expected, with first quarter earnings growth of 24.68% in the S&P 500 on a Y/Y basis.  

On Mobile/Tablet scroll to the right.

Period

1Q2018A

2Q2018E

CY2018E

CY2019E

S&P 500 Earnings Growth

24.68%

18.85%

19.62%

9.87%

S&P 500 Earnings Growth (ex-Energy)

22.39%

15.68%

17.25%

9.56%

S&P 500 Earnings Growth (ex-Energy & Financials)

21.25%

15.16%

15.06%

9.43%

 

What Does It All Mean?

If earnings growth remains strong into 2H2018 as expected, current S&P 500 valuations will be supported. You could even make the argument that it might warrant a further narrowing of the S&P 500 earnings yield – 2-year/10-year yield spreads.

Very simply, future earnings growth will disproportionately drive S&P 500 valuations going forward. The current F12M earnings yield already captures the expectation that earnings growth will remain robust. If continued strength in earnings growth fails to materialize, a contraction in S&P 500 valuation could be possible to keep the spread between the F12M earnings yield of the S&P500 and bond yields in equilibrium.