As the New Year begins I like to take a look at the general landscape of the market as we embark on a new year of investing. As mentioned in my bio, my portfolio is diversified on an asset-class level and my strategic asset allocation decisions are based on my risk tolerance, time horizon and liquidity needs. Prevailing asset valuations will drive my tactical asset allocation decisions and where I invest fresh capital. Because of this, I like to make an annual macro assessment to help me create a picture of the current investment environment.
I am not an economist and I do not have the time, nor energy, to look at every fundamental market driver, so my macro-approach is very simple. I will let the quants crunch the numbers and make predictions while I just want to develop context and get a feel for the market sentiment that I am investing in. There will be many that disagree with my assessment and can lay out a very insightful argument to the contrary. I invite disagreement and discussion and think it is healthy to hear many perspectives. By no means am I an expert in predicting the best return drivers or where the largest risks lie in the current market. However, I believe that having a somewhat clear view of the market landscape will help me stay honest with capital decisions and avoid making un-educated investments. I expect that staying invested over many years, holding a diversified portfolio, and investing with a margin of safety will allow me to avoid excess exposure to tail-risks.
In 2017 the fed continued to stay the course on a rate-tightening cycle, the republicans passed a new tax bill, corporate share repurchases and IPOs continued to demonstrate strong volume, the yield curve has flattened, credit spreads tightened, volatility and inflation remained minimal and assets in general seem, at least at first glance, to be fully valued. Since I look to create alpha with my active investments in the US Equity markets, I will begin my assessment with the S&P 500.
US Equity Markets – Running of the Bulls
The U.S. economic outlook remains healthy according to many key economic indicators. GDP is expected to remain somewhere between 2-3%, coming in around 2.5% in 2017 with the same forecast for 2018 based on the most recent release at the Federal Open Market Committee meeting on December 13, 2017. Unemployment is expected to continue to drop to about 4%, and a successful Republican tax overhaul is expected to bring down corporate tax rates and improve earnings throughout 2018. Furthermore, low interest rates have left investors seeking higher yields outside of the fixed income markets (more on this in another post) and have encouraged investors to search for higher returns and yield in the stock market.
Last year was good for equities as the S&P returned about 21% (includes a 2% dividend yield). With most of the returns coming from price appreciation I think it’s important to ask the question – did valuations stretch further or did earnings keep up with the price appreciation? Earnings growth was 17.6%, thus returns by stocks this year were mostly led by earnings growth, which is a sign that the stock market appears healthy.
The P/E ratio increased slightly (earnings yield decreased by 19bps) and the dividend yield decreased 15bps but maintains a healthy payout ratio of 39.80%. Let’s see how some of these numbers stack up in a historical context:
Looking at data going back to 1960 (57 years) it looks to me like stocks in the S&P 500 are bit on the expensive side. Both the earnings yield and dividend yield are sitting at the low end of the data series, while the PE ratio is becoming stretched – though not reaching the astronomical levels seen during the tech bubble. This concerns me a little bit as returns moving forward may be soft, however, we have been hearing a similar tune from the likes of many market professionals for quite some time now and if you have been sitting on the sidelines during this bull market I’m sure you not happy with the results.
My investment philosophy for my active equity allocation is mainly built around liquidity and safety of principal. As a result, most of my holdings are mid to large cap companies that have a competitive advantage in their industry and pay dividends. One way I like to measure dividend health is by analyzing cash produced by my potential investment in a company and ensure that cash flow is being sustained at a healthy level. I like to see companies use their cash flow to invest back in the business while also providing dividend growth to shareholders without being forced to tap the capital markets to raise funds. Here is a look at net income, free cash flow to equity, and cash returned to investors in the form of dividends and buybacks. These numbers are in millions.
Cash returned to shareholders as a percent of net income and free cash flow to equity is 87% and 98%, respectively. Anything over 100% is unsustainable, so it good to see cash returns below net income, and even better to see cash returns below free cash flow.
After comparing some basic fundamentals to historical numbers and getting idea of cash being returned to investors, I wanted to generate a forward looking estimate of the growth being priced into the current S&P 500 share price. Considering the US market is a developed and fairly stable economy, not currently experiencing an economic boom, I used the Gordon Constant Growth Model to back into an implied growth rate. Using the price and dividend at the end of 2017 (Price = $2,723.39 / Div. = $49.93) and a discount rate of 9% (average required return I use on my individual stock analysis), I get an implied growth rate of dividends of 7%. Does the growth rate justify the price? Well, there’s the obvious argument that if GDP is only growing at 3%-4% per year – than a 7% growth rate in dividends is unsustainable. You also must keep in mind there are inherent flaws in the GGM method as well as the fact that there is room left for the payout ratio (39%) to grow. The average annual growth rate in dividends going back to 1960 is about 6% -so we’re not that far off. Perhaps tax reform and the fiscal growth promised by politicians, combined with a year of healthy fundamental growth has left investors feeling good about future earnings growth. But you can make the argument that even though valuations are lifted in a historical context, investors aren’t pricing the S&P 500 at a euphoric level. (FANG stocks might be a different story!)
Currently, while somewhat healthy, US equities are not providing a sensational margin of safety. It seems like growth and risk are priced in and the market is fairly valued to slightly overvalued. However, I don’t think it makes much sense to look at the stock market in a vacuum and not take a look at what the credit markets are signaling. In Part II I will take a look at the equity risk premium and the prevailing interest rates to further develop context of the environment in which I am investing.
Comments or questions let me know…