Each day market observers try to explain the stock market and experts use algorithms, created by artificial intelligence, to determine equity risk and reward. IDC Financial Publishing has found the best method to forecast stock prices for strong earnings growth and high return on equity is when the S&P 500 is projected at 3-times book value. This value is, in turn, driven by the spread between return on equity and cost of equity.
In this article we test our theories of valuation, using S&P’s reported and projected return on equity (ROE) and IDCFP’s calculation for cost of equity (COE). The COE, as defined by IDCFP, is the 30-year T-Bond yield plus one-half of this yield, plus 20% of the standard deviation of the operating profit margin for a stock market index.
During periods of strong earnings growth, the spread of ROE and COE has risen to 10% (see blue line on Chart I), and full valuation of the S&P 500 has normally been 3-times book value (see black line on Chart I). Periods of price risk occur when the S&P 500 sells above 3-times book value and has led to a price correction in the S&P. Additionally, a major decline in the Housing Market Index (HMI), from a level of 70 to below 60, has forecast an economic downturn, decline in ROE and a major correction in the S&P 500.
Selling at More than 3-Times Book Value Creates Risk in the S&P 500
Risk can occur even during periods of a favorable spread between ROE and COE. ROE less COE spreads of approximately 10% raised the value of the S&P to 3-times book value. However, in 1999, valuations greater than 3-times book value created periods of high risk. In the bull market of the late 1990’s the P/B ratio rose to 5-times book value due to the tech boom. This was a major overvaluation and led to a substantial market correction in 2000.
Price to book value rose to 3-times in 2004 and again in 2007. After the November 2016 presidential election, price to book value rose to 3-times book by year end 2016. The advent of deregulation and tax cuts, however, raised valuations in late 2017 and January 2018 to over 3-times book. A subsequent market correction reduced valuations by April 2018 and eliminated this risk.
Currently, the acceleration in earnings per share for the S&P and high equity reinvestment rate has significantly raised book value estimates for 2018 and 2019, creating favorable price targets in the S&P.
Do Rising Yields on T-Bonds, as Part of COE, Create Risk?
As long as earnings continue to grow as forecasted for the S&P, ROE will expand to 18% (see Chart II). Given this projection, the following determinations can be made about T-Bonds yields and how value of the S&P can manage rising COE.
· A rise in the 30-year T-Bond yield to 4% creates a COE of 6.5%.
· An increase in the 30-year T-Bonds yield to 5% implies a COE of 8%.
· With ROE estimated at 18% and a COE of 6% to 8%, a spread of 10% or more maintains the S&P 500 price target of 3-times book value (see Chart II).
Valuation of the S&P 500 in a Bull Market
The recovery in the spread of ROE less COE to around 10% in 1995-1999, 2004-2006, and 2011-2017 (see Chart I) provided peak valuations of the S&P to around 3-times book value and aligned with the onset of the last three bull markets. As shown in Chart II, despite the moderately lower peaks in ROE, and its slowdown in 2015, the consistent decline in COE is what drove the spread between ROE and COE, and maintained the 10% average.
This year and into 2019, a rise in 30-year T-Bond yields to 4.0% or more, an increase in COE to 6.5% or above, and a ROE-to-COE spread of 10% or wider, all require a high ROE. Book value as of June 30, 2018, is estimated at 877, with a S&P price forecast of 2,631. A continued economic recovery with a full year of corporate tax cuts and other economic stimuli, all forecast book value to rise to 932 in 2018, and 1,046 in 2019. Forecasts for 3-times book value estimate a S&P price target of 2,799 for year-end 2018, and 3,139 for year-end 2019.
HMI a Leading Indicator for S&P 500
The Housing Market Index (HMI) is a survey of realtors’ expectations of home sales, traffic and other housing indicators. HMI was successful in predicting the cycle in ROE for the S&P 500 (see arrows highlighting these graph points in Chart III), For example, the HMI peaked in mid-2005 indicating the peak in ROE in 2007. Additionally, the low in HMI in March 2009 aligned with the low in ROE later that year. Currently, HMI has reached cycle highs and remains near 70, predicting a rise in the S&P 500 ROE over the next two years (see Chart III).
Due to the accuracy of HMI predicting the cycle in ROE, it can also be used to predict the cycle highs in the price of the S&P 500 (see Chart IV). When HMI declined from its peak to below 60, this forecasted each major decline in equities in 1989-90, 1993-94, 1999-2000, and 2007-2009. The current reading of HMI is around 70, indicating the price target of 3-times book value will reach 2,799 in 2018 and 3,139 in 2019, with no indication of a market slowdown.
In the valuation of the S&P 500, only the calculation for COE is unique to IDCFP. The earnings, dividends, book value and ROE are as reported by S&P, or are estimates by Wall Street analysts. The key, therefore, to forecasting the S&P accurately, is IDCFP’s unique formula for COE.
John E Rickmeier, CFA
IDC Financial Publishing, Inc.
700 Walnut Ridge Drive, Suite 201
PO Box 140
Hartland, WI 53029