Our Unique Cost of Equity is the Key to Forecasting the S&P

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 in periods of strong earnings growth and high return on equity is to project the S&P 500 at 3x book value. This valuation is driven by the spread between return on equity and cost of equity.

In this article we test our theories, using S&P’s reported and projected Net Operating Profit After Tax Return on Equity (NOPAT 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 consistently to 10% (see blue line on Chart I), and full valuation of the S&P 500 has normally been 3x book value (see black line on Chart I). Periods of price risk occur when the S&P sells above 3x book value and has led to a price correction. 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.

Chart I

Selling at More than 3-Times Book Value Today Creates a 6.7% Short-Term Price 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 3x book value. However, in 1999, valuations greater than 3x book value created a period of high risk. In the bull market of the late 1990’s the P/B ratio rose to 5x 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 3x book in 2004 and again in 2007. After the November 2016 presidential election, P/B value rose to 3x book by year-end 2016. The advent of deregulation and tax cuts, however, raised valuations in late 2017 and January 2018 to over 3x book. A subsequent market correction reduced valuations by April 2018 and eliminated most of the price risk. A similar overvaluation is occurring in October 2018, creating an 6.7% short-term risk at selling above 3x book value (see Chart I & II).

Chart II

Valuation of the S&P 500 for 2020 Forecasts 21.7% Price Appreciation Potential

The recovery in the spread of ROE less COE to around 10% in 1995-1999, 2004-2006, and 2011-2018 provided peak valuations of the S&P to around 3x book value and aligned with the onset of the last three bull markets (see Chart I). As shown in Chart III, despite the moderately lower peaks in ROE in 2012 and 2014, and its slowdown in 2015, the consistent decline in COE is what drove the spread between ROE and COE and maintained the 10% average in the spread.

This year and into 2020, a rise in 30-year T-Bond yields to 5%, an increase in COE to 8%, and a required ROE-to-COE spread of 10%, are supported by a ROE projection of 18% or above. Book value as of December 2018 is estimated to be 918, with an October 8th S&P price of 2,888. A continued economic recovery with a full year of corporate tax cuts and other economic stimuli, all forecast book value to rise to 1,039 by year-end 2019, and 1,171 by year-end 2020. Forecasts for 3x book value estimate a S&P price target of 3,116 by year-end 2019, for a 7.9% price appreciation potential over the next 15 months. By 2020, this price target is forecast to rise to 3,514, for a 21.7% price gain over 27 months (or 9.1% a year).

Do Rising Yields to 5% on 30-Year T-Bonds, as Part of COE, Create Risk?

As long as earnings continue to grow as is forecast for the S&P, ROE will expand to 18% or more (see Chart III). 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 5% creates a COE of 8% by year-end 2020.
  • With ROE estimated at 18% and a COE of 8%, a spread of 10% or more maintains the S&P 500 price target of 3x book value (see Charts I & III).

Chart III

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 Chart IV & arrows highlighting these points), 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 IV).

Chart IV

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 V). 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 HMI reading of 67 indicates the S&P price target could reach 3,093 in 2019. Strong earnings growth, including ROE of 18%, creates the potential for additional appreciation above 2019 targets, with rising book values reaching 3,514 in 2020.

Chart V

In the valuation of the S&P 500, 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 distinct formula for COE. Also, the COE along with our NOPAT ROE calculations, are key ingredients of “M” in our CAMEL analysis & ratings of banks, savings institutions and credit unions. The “M” represents Margins, which we use as measure of management in calculating IDCFP proprietary rank of a financial institution’s safety and soundness.

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For more information about our ranks, or for a copy of this article, please contact us at 800-525-5457 or info@idcfp.com.

John E Rickmeier, CFA, President, jer@idcfp.com

Robin Rickmeier, Marketing Director