Q2 Market Update

This Q2 market update builds on the analysis in my Q1 Market Update and my updated revision to my stock market valuation model and market rally analysis.

I've updated the S&P earnings estimates and S&P valuation level (which has only dropped slightly from my most recent update). The S&P earnings estimates have actually be reduced from the Q1 estimates, even though people have been getting more optimistic about the economy. Since I use long term trend earnings, I use as-reported earnings as a base calculation. I arrive at forward trend earnings of $53.46, which is slightly higher than the top-down operating earnings estimate.

The market is currently pricing in a 6.9% long term return, in keeping with its post-Lehman norm.

The 30-year inflation assumption is down slightly from the June 15 peak of 2.5%, which has dragged down the S&P value accordingly. I personally believe that at current tax rates the equilibrium return for stocks should be 7.6%. Obviously, there is more risks that dividend and capital gain taxes will rise than fall, which means there is more risk for equity return compression.

At various (pre-tax) return targets, I arrive at the following target S&P levels:

I have 7.6% as an equilibrium return. To achieve such a return, I think the market would need to fall by 19%.

Looking at bond yields (Treasuries by actual yields, the rest as represented by Vanguard bond funds), we have the following levels:

It looks like intermediate and long bonds other than treasuries are fairly valued, long treasuries are roughly fairly valued, and the shorter end of the bond curve is overvalued. I am still in the deflation camp over the inflation camp, meaning I find more relative value being short the inflation hedge (long bonds) rather than long the inflation hedge (long stocks).

In terms of our other inflation indicators, gold at $929/oz. remains above my $1,000 inflation warning threshold, and the dollar is in the middle of its long term trading range against major currencies and is at the top of its range against all currencies.

There appear to be no glaring mis-pricings in the markets today. Boring…

The Recent Market Rally Explained

On April 24, I updated by stock market valuation model and noted it's sensitivity to the assumed inflation rate.  It was fitting that I made that observation, because it appears that virtually 100% of the rally in the S&P 500 since the March 9 bottom can be explained by a rise in market inflation expectations.

Constant assumptions:

Inflation-adjusted 2009 Trend Earnings: $54.94
Normalized Payout Ratio: 50%
Inflation-adjusted Earnings/Dividend Growth Rate: 1.6%

March 9 Inputs:

S&P 500 Level: 680
Implied dividend yield: 4.0%
Implied real return (dividend + growth): 5.6%
Market Inflation Rate (30-year): 1.3%
Total Implied S&P 500 Return: 7.0% (rounded)

June 15 Inputs:

S&P 500 Level: 921
Implied dividend yield: 3.0%
Implied real return (dividend + growth): 4.6%
Market Inflation Rate (30-year): 2.5%
Total Implied S&P 500 Return: 7.1%

This is why the stock market, treasury yields and gold prices have all been positively correlated with each other for the past year.  The stock market hates deflation and adores mildly positive inflation.  To the extent that the Fed and Treasury seem to be successful in promoting reflation, the stock market goes up.  While the market will dislike runaway inflation, as I noted in my post from May 26, that is not currently a threat, despite what many commentators are saying.

So it appears that the market's equilibrium S&P return is 7%, not the 8% that I have been assuming based on historical return premium calculations.  So what changed to reduce the return premium?  Almost all of the drop in return expectations can be explained by the decrease in dividend taxes in the Bush tax cuts of 2003.  It appears that the stock market targets a 2% spread over the equilibrium after-tax return on 10-year corporate bonds.