Almost every day, at least for the past six years or so, investors have been treated to potential “dangers” facing the economy and the stock market. The full list is a long one, but a quick recap includes: Resetting ARMs, Cyprus, the dollar’s reserve currency status, the inventory of unsold homes, Greece, and now a slowdown in earnings coupled with an imminent increase in interest rates.
Of all of them, this last one is an issue that needs to be taken seriously. After all, earnings and interest rates are key components of stock market values. In fact, they are the key components of our capitalized profits market model.
Weakness In Earnings
So when some analysts, whom we respect, highlight the recent weakness in overall corporate earnings growth, we pay attention.
In doing so, we do not lightly dismiss the fact that overall measure of earnings of the S&P 500 have slowed. They have; we’re not debating whether the measurement has been inaccurate. But our analysis says the composition of the slowdown is a critical variable, and because of where the slowdown is occurring, we re-affirm our assessment that there is not much to worry about for the economy as a whole.
The primary component of the S&P which is causing the slowdown is energy. Here’s where it gets a little technical and dry, but we want to layout our case for why worry is not appropriate now.
In recent history, energy stocks made up 10.9% of the S&P 500 market capitalization, and we all know what has happened to energy prices in recent history. Oil prices and natural gas prices have trended down sharply. In fact prices for both are down roughly 40% from just a year ago.
It is only natural that any index containing energy would show the results of that decrease. So, there’s no surprise that the energy sector has dragged down overall S&P 500 earnings.
But there are a couple of further questions that need to be asked before we can draw any definitive conclusions:
- Is the energy sector as important to the overall economy as it is to the S&P?
- What’s happening in the overall economy?
- Are decreases in energy prices ultimately good or bad for the future?
Importance of Energy
When we look at stock values, we look at total corporate profits, not just those of the S&P 500. Often the trend is the same, so the difference is not an issue, but the important measurement is for the economy as a whole.
The energy sector generates only about 3% of total corporate profits. Clearly, the weakness in energy earnings is not as important for the whole economy as it is for energy stocks or indices that have a heavy energy weighting.
The Overall Economy
The overall economy continues to do well. We can’t say we’re happy with the plow horse growth rate, but a lower than desired growth rate is not the same as a contraction. Even with the “slowness” in GDP in the first quarter of this year (due largely to the port strike, collapsing oil prices and another particularly harsh winter), the economy is on track to grow in the low 2% range for 2015. Correspondingly, overall corporate profits are up 4.5% from a year ago. The obvious conclusion is we’re doing fine.
The Effect of Decreased Energy Prices
Every company that buys something, uses it to make something, and then sells that product, wants the prices of what it buys to go down and the prices of what it sells to go up. There’s no magic here. It’s common sense and basic economic theory.
When energy prices decrease we have to ask whether this is good or bad for the economy, not whether it is good or bad for the energy companies. In the short term, the energy companies see profits squeezed. In the long-term, they’ll adjust their costs and profits will rebound.
But for the economy as a whole, decreasing energy costs are a good thing. Every manufacturer or transporter of goods benefits from a reduction in energy costs. Consequently, every consumer of the products made with energy, or transported by something using energy, benefits from decreasing prices of those products.
Decreases in the energy costs is a net advantage to the economy. More companies and people are benefited than the ones (the energy companies) that are hurt. Decreasing prices of this sort means that our standard of living has increased; we are wealthier as a result.
Stock Prices And Interest Rates
Even if we acknowledge that all these corrections and redirection of prices and the earnings of individual sectors haven’t hurt the economy, we still need to determine whether the market is fairly priced and what affect the coming interest rate increases will have.
This is why we use a capitalized profits model to assess stock market value. We use overall after-tax corporate profits discounted by the 10-year Treasury rate. In spite of everything being written about the current “dangers”, we still see the S&P 500 as undervalued.
With the current 10-year Treasury yield at 2.35%, our model says the “fair value” of the S&P 500 is 4,335. This does not mean that we try to accurately determine the S&P 500 down to the level of precision that any formula tends to imply. We only use this in a broad sense to determine whether we’re clearly over, under or at a fair value. Differences within each range are not that accurate or important.
Today, the S&P 500 is undervalued (it stands at 2,109 as we write). Of course, the Fed will be increasing rates. Perhaps this occurs as soon as July, but it may be sometime in the fall. Irrespective of the timing this year, the question becomes what would the fair range for the S&P 500 be with higher interest rates?
If we us a more historically normal rate of 4% for the 10-year Treasury, the “fair value” of the S&P would be 2,550. That would still make the S&P 500 about 17% undervalued. It would take a 10-year Treasury in the vicinity of 4.8% coupled with no growth in corporate profits for the model to suggest stocks are fully valued.
None of this means we won’t have a “correction” in stocks at some point. Markets still have their emotional components. Irrational exuberance as well as irrational fear still grip people and investors from time to time. These swings cannot be predicted, nor can we time them in any fashion. They are just part of the short-term volatility that gives us the long-term growth that broadly diversified stocks do. What it does mean is that today’s “danger” is once again overstated. The apocalypse is not around the corner.